Can the Fed Avoid a Taper Tantrum?

Maybe, but probably not entirely. Still, the market response can be tempered by careful communication. This is the time for FOMC participants to discuss how to do so before the FOMC communicates the start of tapering.

It is important to appreciate, however, that the circumstances today are different from what they were at the time of the Taper Tantrum in 2013, specifically as a result of the new policy framework and the guidance about both tapering and liftoff. The guidance is outcome-based, not calendar-based; and while the preconditions are quantitative and relatively clear for liftoff from the ELB (effective lower bound), the preconditions for tapering are qualitative and hence subject to judgment by the Committee.

The markets are left to anticipate when the Committee will judge that there has been substantial further progress, which leaves considerable uncertainty. Of course, markets are forward-looking and will not wait for communication about tapering from the Committee. Markets are already pricing in early 2022 for the beginning of tapering. Going forward, markets will update expectations based on quantitative thresholds that they associate with the FOMC’s qualitative precondition of “substantial further progress” toward the dual-mandate goals.

What can the FOMC do to limit the market reaction to the announcement of tapering? First, and obviously, the announcement that tapering will begin should not be a complete surprise to the markets. And communication about tapering should have gradually been pointing to that date.

Second, the FOMC should remind markets about the preconditions for the start of tapering and the difference between the preconditions for beginning tapering and those for liftoff from the ELB.

Third, even as the Committee has communicated (both explicitly and indirectly) that tapering will likely conclude before liftoff, it should make this sequence more explicit.

Fourth, it also should announce when the Committee anticipates tapering will be completed. That, in turn, would provide an estimate of the size at which the balance sheet is likely to stabilize as a result of the Committee ending net asset purchases, and before any decision about how to reduce the size of the balance sheet. If the time of the anticipated completion of tapering is perhaps a year before the expected date of liftoff, that should also limit the
market response.

What should they do if there is a tantrum? Communication after the event, if communication before does not get the job done. A tantrum is about markets moving up their expectations of liftoff, following the earlier-than-expected tapering. The FOMC can remind the market of that and emphasize that inflation will rise very gradually to 2% and that it will take even more time before the participants project a sufficient overshoot to be consistent with the liftoff preconditions. Powell could remind the market that the last time the unemployment rate reached 31⁄2%, inflation had not yet reached 2% sustainably. Damping the market response or suppressing it will depend importantly on whether the Committee has revised its macro projections and hence its rate projections as reflected in the dot plot. If there is no change in the dot plot, the Committee should emphasize that the earlier-than-expected tapering is not accompanied by an earlier-than-expected projected liftoff.

What should the Committee not do? Dudley recently said that, if there were a taper tantrum, “the Fed can respond by halting the tapering process or pushing back the date when it plans to start increasing short-term interest rates (or both).” No on both accounts. First, the guidance is outcome-based, not calendar-based. So forget about changing the date. Second, doing so would amount to scrapping the forward guidance and indeed deviating from the new framework at the first time it became relevant. Credibility lost! Importantly, Committee members should not have a tantrum about the tantrum in the market. It too will pass. Some will win and some will lose. So it goes.

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