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PIMCO: Substantial Further Progress? Not Yet, Says the Fed

By Tiffany Wilding, US Economist at PIMCO

The statement and press conference following the July U.S. Federal Open Market Committee (FOMC) meeting reinforced PIMCO’s outlook that in the second half of this year, the FOMC will announce it plans to begin to wind down its large-scale asset purchases. Indeed, the July FOMC meeting statement acknowledged that progress has been made toward the committee’s inflation and maximum employment goals, but stopped short of calling it substantial. Nevertheless, the FOMC also indicated its plans to continue to assess this progress “in coming meetings.”

We think these statement changes leave open the possibility that the Fed could announce the first reduction in the pace of its bond purchases as early as September, but reaffirmed our view that December is the most likely timing for any announcement. In his post-meeting press conference, Fed Chair Jerome Powell confirmed that the FOMC still intends to give “advance notice” ahead of any decision, while stating that the labor market still had some “ground to cover” before substantial progress is achieved.

In any case, the statement and press conference confirmed that the FOMC had an in-depth discussion on the outlook for the large-scale asset purchase programs (LSAPs). In particular, we think these discussions likely encompassed three key questions, which we expect the Fed to answer in the weeks and months ahead: When should tapering begin? What is the optimal plan and schedule for diminishing purchases (e.g., should mortgage purchases be tapered earlier or faster than U.S. Treasuries)? And how will the Fed communicate its tapering plans in an effort to alleviate market volatility?

In what follows, we discuss our views on the “when,” “what,” and “how” questions.

When to taper?

On the timing of any tapering announcement, the Fed has said it will continue the current pace of asset purchases “until substantial further progress” is made toward its dual mandate on price stability and employment. Depending on the FOMC’s interpretation, we think this goal could be met as early as September, but more likely December.

On the price stability side of the mandate, there is no question that U.S. inflation has made substantial progress. U.S. Core CPI (consumer price index) inflation, for example, jumped to 4.5% (year-over-year) in June – overshooting the Fed’s target. However, because the sources of the strength in inflation were either the categories suffering from acute supply constraints (new and used vehicles and auto rentals), some of which may already be easing somewhat, or categories that suffered the largest declines as a result of social mobility restrictions (airfares and hotels), the June CPI report likely didn’t change the narrative that the recent inflation spike is just that: a transitory spike. Furthermore, despite the acceleration in realized inflation, longer-term inflation expectations still appear aligned with the Fed’s longer-term 2% target.

Where there is more room for discussion is around what “substantial further progress” means for the U.S. labor market. We see two questions: First, has the level of maximum employment changed since the pandemic? And second, how small does the remaining gap between actual employment and maximum employment need to be before Fed policymakers are comfortable with announcing tapering?

Maximum employment is a highly uncertain moving target. Every year, positive population growth contributes to labor supply and increases the level of maximum employment. A strong labor market can also increase the level of maximum employment, while notable economic shocks (recessions, productivity booms, import competition, etc.) may also have a significant impact.

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