Fed Officials Begin Tapering Talks, But Markets are ‘Very Sensitive’ and Maybe ‘Underestimating’ the Risk

In prepared testimony released late on Monday, Federal Reserve Chairman Jerome Powell said the US economy continues to show “sustained improvement” and forecasted a decline in inflation from current elevated levels and further job market gains.

Powell did not say anything about the tapering debate this time.

St. Louis Fed President James Bullard and Dallas Fed President Robert Kaplan meanwhile laid out some of the major questions that central bank officials will have to grapple with.

“No one really knows how this is all going to unfold,” Bullard said during the virtual event organized by the Official Monetary and Financial Institutions Forum and the Philadelphia Fed.

“We have to be ready for the idea that there is upside risk to inflation and for it to go higher.”

Taking Off The Foot Gently Off The Accelerator

Speaking on the same panel, Kaplan noted that the economic crisis involved a significant lack of demand, which was helped by the purchases of treasuries and mortgage-backed securities, and argued that now the economy is seeing strong demand.

The Dallas Fed president also shared his concerns over the frothy housing market and the potential for easy policy to feed “excesses and imbalances.”

“I’ve been more of a fan of doing some things maybe to take our foot gently off the accelerator sooner rather than later so that we can manage these risks.”

According to him, this is simply a reaction to the “dramatically improved economic outlook.”

New York Fed President John Williams then signaled it is too early for any turn in policy yet.

While the economy is improving at a “rapid rate,” with the medium-term outlook “very good,” Williams said in his prepared remarks,

“Data and conditions have not progressed enough for the FOMC to shift its monetary policy stance of strong support for the economic recovery.”

Markets Underestimating The Risk?

Speaking at the Qatar Economic Forum, billionaire investor Ray Dalio said on Monday that the Fed could achieve its desired results with relatively modest actions.

“It’s easy to say that the Fed should tighten, and I think that they should,” said Dalio, the founder of the world’s biggest hedge fund, Bridgewater Associates.

“But I think you’ll see a very sensitive market, and a very sensitive economy because the duration of assets has gone very, very long.”

While former Treasury Secretary Lawrence Summers remained more strident, sharing his concerns over inflation going much higher than Fed’s 2% target, another former Treasury Secretary, Steven Mnuchin, said investors are not prepared for tightening monetary policy.

“There’s no question the Fed needs to go into a period of normalizing rates and normalizing the portfolio” of bond holdings, said Mnuchin, adding, “I do think the markets are underestimating this risk.”

The stock market recovered beautifully on Monday from last week’s losses while the crypto market remains affected by Fed’s shift in policy and added pressure from China cracking down on crypto trading and mining and lack of inflows.

Fed’s Williams also talked about central bank digital currency (CBDC), saying the central bank is still in the research phase and trying to figure out its use cases. However, the FedNow real-time payment settlement system is the priority for the Fed, he said.

He further said the US faces different questions than other countries when it comes to a CBDC because it has the world's reserve currency. Meanwhile, Kaplan said, it’s unrealistic to expect the US to be the world’s reserve currency permanently.

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