The taper is coming. That much is certain. Recent reporting indicates the Federal Reserve may move ahead as early as September.
“It looks like they are probably turning the corner,” said Mike Englund, principal director and chief economist for Action Economics.
Three Fed officials all over the U.S. map spoke up in recent weeks about the taper. Dallas Fed President Robert Kaplan told CNBC that it’s time for the Fed to taper in the fall, starting the actual program’s end in October. Richmond Fed President Thomas Barkin said “we are closing in on tapering” though he wasn’t more specific. San Francisco Fed President Mary Daly said a few weeks before her colleagues that the taper could come “later this year” or in early 2022.
Interviewed on CNBC earlier this week, Boston Fed President Eric Rosengren said he could be ready next month to begin.
Many market watchers feel that the Fed has been so much more communicative this time around that the taper, when it starts, will be a “ho hum” event for investors, and that is the way the market is acting so far. Stocks continue to sit near records, even though they’ve been weak in recent days, and bond yields remain depressed. But there is a lot the economy and markets still don’t know about the Fed’s taper plans, and the ripple effects. Here are a few of the major issues.
1. Consumer prices may have hit peak inflation, but that does not go for housing rentals
Last week there was a lot of focus on the Consumer Price Index coming in cooler than expected and hot areas like the used car price index declining into August. There was relief, to be sure, in the latest CPI.
“We had good news from CPI in the topping of the most volatile components,” Englund said.
But housing rentals — and the broader issue of housing affordability — remain a major pain point for the average American. It also reflects a housing market that remains majorly imbalanced between supply and demand.
“People want more residential real estate and less commercial, and you can’t just convert it. We have partially filled skyscrapers and a large number of people who now work from home, so the demand for residential has gone through roof compared to the existing stock,” Englund said.
In July, rents nationally rose 7% year over year for one-bedroom apartments and 8.7% for two-bedroom apartments. The multifamily rental industry set a record in July, with rents rising 8.3% year over year and single family rentals up 12.8%, according to Yardi Matrix data.
The problem in housing rentals is not one created by the pandemic, and dates back to at least the financial crisis. The U.S. housing market has been used to adding 1 million to 2 million units a year in terms of supply, and when you look at the recent housing starts numbers, the industry is struggling to get to 2 million.
“Now with supply constraints for carpenters and electricians, and everyone else, we are probably at our capacity of what we can build,” Englund said. “We have 100 million homes but you can only build 1 million to 2 million a year, and people need 10%-15% more housing.”
The National Association of Realtors estimates that it is a two-year construction shortage, and that’s why rents are being pushed up.
The pandemic has added to pressures in the housing market. While the eviction moratorium is necessary for the hardest-hit Americans, it also has the effect of lowering the supply of available housing for rent on the market.
But what is unaffordable to most people works to the advantage of those most financially secure. “Cash purchases of homes are going up even as we see double-digit price increases in homes,” Englund said, driven by people at the very high end of the income distribution.
“Looking at the data since the turn of the year you could have thought that maybe the Fed should have accelerated the tightening process. These policies don’t shift spending from underspent areas. People buy more of what they already have. A handful of us bidding prices of homes upwards,” he said. “It’s not clear how the problems associated with the pandemic were helped by driving up asset prices and almost everything looks like a bubble,” he added.
It is worth noting that shelter (the CPI parlance for housing) is the largest component of the index by weight, but it is equally important that it is not the inflation measure the Fed is likely to focus on in policy decisions, according to experts like Englund, especially compared to wage inflation and the labor market. And the housing market is one where no single Fed decision on the taper timeline is going to solve the supply demand challenge.
2. Inflation is still running very hot among producers
As the CPI declines, big gains continued last week in the latest Producer Price Index. Shortages in supply chains, such as the chip shortage rattling auto production, could last into the end of the year.
The latest PPI numbers show that the wholesale side of the economy continues to be under a lot of pressure with producers still facing broad price increases.
That is not a surprise. Economists started the year arguing there would be bottlenecks, but even those like Englund are surprised by how deep the bottlenecks are.
“These shortages have been maintained in doorknobs and everything else you bought on Amazon,” he said.
Englund said when comparing the latest CPI and PPI numbers, it is the latter that are more notable. “The PPI was more significant because of the numbers, because of the sheer size of not seeing cooling at the wholesale level, but the CPI was encouraging for some topping,” he said.
Sam Stovall, chief investment strategist at CFRA, said the PPI data, which remains hotter than expected, keeps inflation concerns alive, but monthly gains are expected to start to edge lower as we head towards year-end.
3. The stock market seems okay with inflation
Stovall said the CPI number ended up being a market driving event to the upside, with inflation still high but the slight tick downwards from last month leading investors to assume that at least from the consumer inflation perspective it is manageable, and maybe the Fed has more, not less, flexibility about waiting a little longer to announce when the taper will take place.
“They are pretty certain they are going to announce and enact tapering by the end of this year and what slightly softer CPI data might allow them not to say in August or September, to delay, would just be statement rather than intent and action.”
The record stock market is saying inflation is good for stocks, according to Stovall. “It is an indication that the economic recovery is occurring and because much of the inflation is likely to be transitory, that means economic expansion and earnings improvements will outpace inflation,” he said. “In other words, you end up with more money left over at the end of the month.”
4. PPI might speak for the Fed hawks, but maybe not Powell
The continued inflation in the supply chain could lend an argument to the Fed hawks who want to pull back right away, but Powell speaks for the center and he hasn’t shown much of indication he wants to tighten, at least not yet.
“Whether these numbers change it, is unclear,” Englund said.
Englund isn’t convinced the taper timeline will begin formally in September because of the “center” that Powell represents.
“They’ve probably talked it to death, but I don’t think they want to tell us in September,” he said. And if there is not enough momentum to move the center, the Fed may stick with its “closing in on tapering,” advance the ball messaging, but not go so far as to give a timetable in September.
“If you are focusing on the economic problems of inner cities you want to delay tightening as long as possible, even if you know you will have a bigger inflation problem. If all you have is a hammer, everything looks like a nail,” Englund said. “But the broad macroeconomy, clearly 80% is bursting at the seams,” he added.
The Fed also has “the cover” of the delta variant, right now, as a reason to move more slowly, though so far it’s hard to see its effect on the economy, Englund said. Recent consumer sentiment and retail sales numbers did experience big declines. But once the Fed starts the conversation about the taper, it is harder to stop.
“They may have gotten over their skis when they start signaling the timing of taper because it is hard not to progress the conversation once they start it,” Englund said. “If they can get through the September meeting without giving the market a timeline that pushes the timeline back to November, which is where they would have wanted it anyway.”
Action Economics continues to think Powell will want more evidence of “substantial further progress” beyond the recent data.
“I certainly wouldn’t want to wait any later than December. My preference would be probably for sooner rather than later,” Rosengren told CNBC this week.
The latest clue from the Fed came Wednesday, when the minutes from the central bank’s July meeting were released. The minutes showed Fed officials are preparing to taper bond purchases before year-end.
5. The Fed’s trial balloons could be misinterpreted by market
Stovall sees the recent comments from regional central bank presidents as “the Fed floating trial balloons, trying to be as transparent as possible and dissipate a potential taper tantrum like we saw in 2013.”
It’s working so far, though not all investment experts are convinced there won’t be more volatility in markets ahead, with Wells Fargo Securities head of macro strategy Michael Schumacher telling CNBC on Tuesday that he remains concerned about a market that is treating the taper as a ho-hum event. He doesn’t think the taper is fully baked into bond and stock markets.
Stovall said the more the Fed talks about the possibility of tapering, the more that conversation continues into the September meeting and an announcement tapering will start by the end of this year is what Wall Street now expects, and Wall Street will not react as negatively as it might have otherwise.
“My best guess is they message it in September and announce the taper in November, but they may not even wait until 2022. It may be December,” Stovall said of when the Fed formally starts easing its bond purchasing.
6. Once the taper is set, it’s onto rate hike timeline and the impact on stocks
Once the taper timeline is clear, there’s the next big Fed watch to move onto, which is the first rate increase. Stovall said investors may not need to worry as much as they would think.
Historically, going back to 1945, in the six months after the Fed starts raising rates, the Dow Jones Industrial Average fell, but only by an average of 0.2%. Over 12 months after a first rate hike, the average gain in the Dow is 2.5%. There is no doubt, though, that a cutting cycle is better for stocks than rate hikes. In the first six months after a rate cut, the average gain in the Dow since 1945 is 11%, and 17% over a full year.
There is reason to believe a more communicative Fed, if it can taper without causing a market selloff, can also lower the risk of a major market surprise when it raises rates.
Stovall said the current stock market reminds him of the late 90s, in that the market “just does not want to go down,” driven by large-cap tech and consumer discretionary giants.
That means the Fed timing on the taper and hikes, and the pace of those policy shifts once started, will loom large for the markets.
“Between now and December it will be tapering along with inflation and employment, and as we go into 2022, it’s the speed of the tapering and the timing of the first rate increase, and then the number and magnitude of those rate increases,” Stovall said.
