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Even though the U.S. is ahead of Canada in emerging from the pandemic, it might well lag its northern neighbour on the path towards policy normalization. If so, as I discussed in my previous article, the reasons might have to do less with different economic conditions between the two countries than with the emerging heterodoxy of the central banks on inflation.
Late last summer, the Fed adopted a flexible average inflation targeting (FAIT) framework for monetary policy, which in effect means it will tolerate above-target inflation for a certain period if the economy has not yet achieved sustained full employment, which is somewhere around a 4% unemployment rate. That is a significant shift, and it reverses a course the Fed set 40 years ago under inflation hawk Paul Volcker, which emphasized fighting inflation even at the short-term expense of employment. Today, the Fed under Jerome Powell has firmly placed inflation concerns on the back burner – at least until the data confirm that full employment has not only been achieved, but can be sustained.
The impact of this shift can be inferred from the latest Fed DOT plot, which shows that bank officials expect full employment to be achieved by the end of 2022, but the funds rate to remain at zero through to the end of 2023. This might have some investors accustomed to Fed proactivity scratching their heads, but it is perfectly consistent with the new framework. By most indications, the Fed seems concerned about winding down QE or raising rates too early, as it has done in previous cycles. And it seems just as cautious about avoiding any signals that it will contemplate tightening until its employment goal is achieved.
The market currently expects a hike in the first half of 2023 or even late 2022, and Fed officials undoubtedly would be happy to be proven wrong by the economy achieving full employment sooner than they expect. But perhaps the only way they would be willing to begin withdrawing stimulus through rate hikes is to get to the destination first – it will not happen along the journey.
What does this mean for the outlook on tapering? The Fed seems committed to giving markets plenty of transparency – which is a delicate task to say the least, given that markets will react as soon as there is any hint of a move. And it will take some time to taper bond-buying down from $120 billion a month to nothing. The last time the Fed undertook quantitative tightening, in 2013, they reduced bond purchases at a rate of $10 billion a month. At that pace, it would take a year to reduce QE to zero. Put it all together, and we can sketch out a potential timeline.
Let us assume a rate hike in mid-2023, halfway between market and Fed expectations. Given that officials have said they would complete the QE wind down before undertaking any rate increases, the Fed will need to finish tapering before 2023 – it probably would not want to hike rates a month after tapering to zero. If we back up a year to complete the tapering process, then the Fed will have to start talking about it sometime in the second half of this year. Opportunities might be the Jackson Hole Economic Symposium in mid-August, or the release of the Fed’s September policy report, which coincides with the Federal Open Market Committee (FOMC) meeting in late September.
So the outlook on the Bank of Canada and the Federal Reserve presents a tale of two tapers. For the BoC, the economic data suggest aggressive QE is probably no longer necessary and might be becoming worrisome. And because it still acts like an orthodox central bank – proactively moving to stem above-target inflation – it makes sense to curtail QE sooner rather than later and to move rate-hike expectations forward.
By contrast, the Fed may not talk about tapering until later this year and could wait until either side of year end to begin the process. It could have to raise rates sooner than 2024 – perhaps much sooner – but it is unlikely to change its rhetoric in the meantime. If anything, the Fed would be happy to be proven wrong and have to withdraw stimulus sooner than it is projecting, but that will only happen if and when the goal of full employment is successfully attained, or at least clearly in sight.
This last point is crucial, not just because it shows the divergent paths of Fed heterodoxy and Bank of Canada orthodoxy, but also because it demonstrates the dramatic implications of the Fed’s shift to average inflation targeting. Having introduced the new regime just a few quarters ago, Fed officials are adamant that they will not change their approach. The Fed will not risk losing credibility by switching course so soon after adopting a substantially different framework.
David Stonehouse, Senior Vice-President and Head of North American and Specialty Investments, AGF Investments Inc., is a regular contributor to AGF Perspectives.
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© 2021 by AGF Ltd. This article first appeared in AGF Perspectives. Reprinted with permission.
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