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All eyes on tapering as economic recovery continues

In the last one month, the US labor market has witnessed immense recovery and the rhetoric of policy normalization has gained pace. The Fed too has responded by clearly hinting at tapering, but has taken into account persisting labor market slack and risk of premature policy withdrawal. High frequency indicators (HFIs) for the US show the economy is still in recovery mode. Primary headwinds in the upcoming months would be mutant variant of the virus and entrenched inflation with labor market slack. Tailwinds remain in the form of consumer spending, ultraaccommodative policy mix and vaccination coverage.

Pandemic injecting randomness to policy reaction

Rising Covid cases in the US underpinned by the Delta variant are injecting randomness in policy reactions, especially monetary policy. Latest data shows that the Delta variant has 100% share in the cases confirmed since June. As of August-end, daily confirmed cases have doubled to 160.4k compared to 80k as at the beginning of the month. While the cases are going up exponentially, the pace of vaccination remains linear, as vaccine hesitancy is prevalent among the US population.

However, three comforting points emerge for the policy makers: (1) surge in cases is constrained to the southern part of the US, (2) hospitalized and ICU patients as a % of confirmed cases remains below average since the pandemic started and showing signs of decline, and (3) US has fully vaccinated 53% of its population and 62% of the population has already received 1 dose. Booster shots are becoming available and until factor number 2 goes out of hand, we don’t see any economic hit to the US economy or the Fed discontinuing on its path to tapering.

Economic recovery continues; inflation projections for 2021 revised upwards

High frequency indicators (HFIs) signal that the US economy is on track for a recovery after the pandemic bottom but the recovery is not complete. Retail sales and real wages for the month of July remained muted. Combination of all the indicators shows the sectors that were hit by the pandemic are showing turnaround, but the turnaround remains sporadic.

An interesting point that caught our eye is that falling unemployment rate is not being accompanied by rising personal income. Personal income increased by 1.1% YoY in July – an 80bp drop from June, while unemployment rate decreased by 50bp in July to 5.4% compared to June.

On the inflation front, supply side bottlenecks and reopening disequilibrium are longer than expected. Hence, we revise our CPI forecast for 2021 to 4.4% from 3% earlier and see core CPI at 3.5% with risks broadly balanced. Also, we revise PCE inflation to 4% from 3.2% earlier and see core PCE at 3.6% with risks broadly balanced. But, we see inflation levels coming down to 2-2.5% next year, consistent with the Fed’s goals, as supply bottlenecks recede and reopening is complete.

The labor market added 943k jobs in July, mostly from the leisure and hospitality sector (380k). Initial jobless claims fell to the lowest levels post pandemic to 366k for the week ended 21 st August. But still, the labor market slack persists to the tune of 5.8mn and the broader unemployment rate (U-6) remains elevated at 9.2% but below a decade’s average of 10.8%.

Policy landscape and outlook

Given the current condition of the labor market and the inflationary pressures, we reiterate our view that tapering would start early next year, with the announcement coming next month. Although labor market slack persists and unemployment rate remains stubbornly high, there is clear visibility of job addition in upcoming months, as job openings have mounted to a record 10mn. These openings will start to fill once the fear of the pandemic recedes – the US has vaccinated >53% of the population.

Judging by the market movements as FOMC spoke about tapering, it seems there is very little risk of tantrum. But, in our view, risk will come from the pace and composition of tapering – if it’s according to market expectations, not an issue, but otherwise, it can create volatility not only in US markets but also globally, especially when valuations are stretched at the back of ample liquidity. The rate hikes will be the last resort and will come once the labor market has reached near prepandemic levels. We retain our stance of no rate hikes before 2023.

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