By Greg Robb
The aftermath of the coronavius pandemic has created so much ambiguity about the U.S. economy that Federal Reserve officials could find themselves seriously divided over the proper course of action, a rare experience for the central bank. Divisions might be revealed in the open next year.
For decades, Wall Street has become used to a U.S. central bank where “dissents have been isolated,” said Steve Englander, head of North America Macro Strategy for Standard Chartered Bank. Uncertainty over policy could lead to volatile markets.
Englander said the Fed disagreement over the economy is not ideological. There are just different points of view.
“I think everyone respects [Fed Chariman Jerome] Powell, and its not like the Democrats and Republicans in Congress,” he said.
Fundamental questions are being debated among Fed officials. Is the labor market tight or loose? Will the spike in inflation be temporary or long-lasting? Is the health of the recovery still uncertain?
“Right now, the economy is in a state of flux — it’s a state of constant change and churn,” New York Fed President John Williams told reporters earlier this month.
Supply and demand are moving very quickly, with some parts of the economy experiencing slack and other parts very tight, he added.
The Fed’s interest-rate committee, formally known as the Federal Open Market Committee, is fairly dovish this year, and there have been no dissents to the leadership of Powell.
But next year, the four regional Fed presidents who have a vote on policy are all heavily hawkish, Englander notes. He sees the possibility there could be as many as five dissents or more to policy decisions.
“It is even possible that Fed Chairman Jerome Powell could be outvoted,” Englander said. A Fed chairman being in the minority has not happened since the 1980s.
Rotating onto the FOMC in 2022 are St. Louis Fed President James Bullard, Kansas City Fed President Esther George, and Boston Fed President Eric Rosengren. These three officials have called for the Fed to taper its bond purchases sooner rather than later. Cleveland Fed President Loretta Mester will also be a voting member of the FOMC next year. She hasn’t been as hawkish but still would like to see the asset purchases end by the middle of 2022, earlier than many doves.
The FOMC “will look hard for ways to avoid such a split in its ranks,” Englander said.
Powell has championed a new dovish policy framework, under which the Fed has said it will hold interest rates close to zero until the labor market has hit maximum employment and inflation has risen to 2% and is on track “to moderately exceed 2% for some time.”
Carl Tannenbaum, chief economist at Northern Trust in Chicago, thinks the Fed’s new strategy on raising rates is too opaque.
“The Fed did not tell us over what time period they wanted inflation to average 2%. They did not say there is a level of periodic inflation that would be too high,” he said.
“So we really don’t know where the tripwire is or how they would inject the data that’s incoming. That’s why we’re back to parsing statements and clues. If their intent was to make things more transparent, they have not been successful,” Tannenbaum added.
Former New York Fed President William Dudley said Monday he wished the Fed was a little more flexible about when it would be willing to raise interest rates.
“The current regime, where they don’t do anything until they reach the maximum state of employment in their mind, might turn out to be too late,” Dudley said in an interview on Bloomberg Television.
A period of calm could persist for the first half of 2022 and the Fed can “wait and see” about inflation, Englander said.
Over this time, Powell is likely to continue to stress that the timing of the taper “will not be intended to carry a direct signal” on the timing of any rate hikes.
The hawks are also not seeking to spook markets and are keeping their powder dry months before the Fed is in any position to make a decision.
“Even the most hawkish hawk sounds very nice, [saying] the economy is going to be where it is supposed to be so we can move quicker. I think they are trying almost purposefully to avoid a situation where the market says ‘oh my god, these guys are really hawkish and they’re on the warpath’,” Englander said.
The consensus is that the Fed won’t start to raise interest rates until after it has slowly ended, or tapered, its purchases of $120 billion of bonds each month. That could take six to eight months depending on the pace.
At their meeting this week, economists think the Fed will drop a big hint that it will begin to taper asset purchases this year.
Fed hawks care more about when the bond purchases end than when they start.
Hawks want the Fed to have ended its asset purchases by next June to leave room for one hike. And if inflation remains high, they might press for two hikes, Englander said.
The worst case scenario for Fed officials next year will be ambiguous data.
For instance, if the core rate of inflation is running around a 2.7% annual rate next year, the hawkish FOMC voters may view this as signaling a need to act, while doves may wish to give inflation more time to dissipate on its own, Englander said.
The result could be a deadlocked committee and market uncertainty.
The yield on the 10-year Treasury note (XTUP:BX:TMUBMUSD10Y) rebounded somewhat Tuesday after slumping on Monday fears of contagion from a weakening property sector in China. The timing of future interest rate hikes is drawing the attention of bond traders and analysts.