Goldman Issues Q&A On Tapering: Says "Not Yet"

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On one hand we have bad Hilsenrath sending mixed messages saying the Fed may taper sooner (with good Hilsenrath chiming in days later, adding it may be later after all), depending on whether HY bonds hit 4% YTM by EOD or mid next week at the latest. On the other, even resolute Fed doves are whispering that a tapering may occur as soon the summer, so in a few months, and halt QE by year end. Bottom line - confusion. So who better to arbitrate than the firm that runs it all, Goldman Sachs, and its chief economist Jan Hatzius, who issues the following Q&A on "tapering." His view: "not yet." Then again, Goldman is the consummate (ab)user of dodecatuple reverse psychology, so if Goldman says "all clear" the natural response should be just as clear.

From Goldman Sachs' Jan Hatzius:

Q&A on Fed Tapering: Not Yet

Q: What are your forecasts for the future of the Fed’s QE program?

A: We expect continued purchases at a $85bn/month pace through 2013, followed by a gradual tapering process toward zero that starts in 2014Q1—presumably announced at the December 2013 FOMC meeting—and ends in 2014Q3. This is based on our forecast that real GDP will grow 2% in Q2/Q3 and 2.5% in Q4, the unemployment rate will fall to 7.3% by the end of 2013, and core PCE inflation will edge up a bit to 1.3% year-on-year by Q4.

Q: How do you see the risks around this central forecast?

A: Roughly evenly balanced between an earlier and a later move. It is likely that the FOMC will want to announce the first reduction in the pace of QE at a meeting followed by a press conference, so that the Chairman can explain the context of the decision. The next four press conferences are scheduled for June 19, September 18, December 18, and March 19. In our view, a tapering announcement is highly unlikely for June 19, possible for September 18, most likely for December 18, and also possible for March 19 (or potentially even later). All of this will, of course, depend first and foremost on the output, employment, and inflation data.

Q: Have you increased your probability of an early tapering step—say, before the September meeting—over the past few months?

A: No. Such a step would imply a hawkish shift at a time when the incoming information has, if anything, pushed in the other direction. As of the March 19-20 meeting, it seems that the median committee member believes that “…if the outlook for labor market conditions improved as anticipated, it would probably be appropriate to slow purchases later in the year and to stop them by year-end.” We believe that “later in the year” means no earlier than the July or—more likely if a press conference is required—September FOMC meeting.

Since the March meeting, economic activity has, on balance, disappointed expectations. Although the weakness in the employment and retail sales reports for March was reversed in the reports for April, the US manufacturing sector continues to slow, with declines in industrial production in April and the NY Empire State and Philly Fed reports in May. Moreover, the latest spike in initial jobless claims raises at least some questions about whether the downward trend in claims that was previously evident is still in place.

Perhaps more importantly, inflation has continued to fall in recent months. Following the lower-than-expected April CPI report, we estimate that the core PCE index slowed to 1.0% year-on-year in April. Although other indicators of the underlying inflation trend have been consistent with slightly higher inflation, our core inflation “tracker” now stands at an estimated 1.3% for April, clearly below the 2% target.

Q: So you don’t read much into the recent increase in press and market chatter about tapering?

A: Not really. A significant part of this chatter seems to be based on an article by Jon Hilsenrath in the Wall Street Journal on Friday evening. But although the headline “Fed Maps Exit from Stimulus” sounded dramatic, the article itself contained little new information on the key question, namely the timing of any tapering moves. It merely stated that ”some” Fed officials "can envision" taking the first step toward tapering soon. This has been clear for many months; in fact, “some” Fed officials have been uncomfortable with the program from the get-go and would of course like to end it as soon as possible.

Q: But didn’t the Hilsenrath article provide quite a lot of information about the shape of the exit process, i.e. the likelihood that the sequencing of the QE tapering will be very sensitive to economic conditions?

A: Again, not really. The FOMC has been trying for a while—going back at least as far as the March press conference and continuing through the May 1 statement—to convince market participants that the tapering process will be less "deterministic" than many have been thinking. The purpose is probably to reduce the extent to which market participants would extrapolate forward a small reduction in the QE pace at one meeting into additional reductions at subsequent meetings.

But even this point needs to be qualified. In our view, Fed officials have an incentive to portray the tapering process as less deterministic than it is likely to be in reality. Uncertainty about whether an initial tapering step foreshadows additional steps at subsequent meetings would probably keep the initial tightening in financial conditions more limited. This would be desirable from the Fed’s perspective. For this reason, we would take the FOMC’s signals on this issue with a grain of salt.

Q: Where does the recent Fedspeak fit in?

A: We have not received a lot of new information since the May 1 statement, which was quite similar to the prior March 18 statement. Perhaps the most interesting update came from a speech on May 16 by San Francisco Fed President Williams. He remains less enthusiastic about continuing the QE program than we would have expected a few months ago: "[A]ssuming my economic forecast holds true and various labor market indicators continue to register appreciable improvement in coming months, we could reduce somewhat the pace of our securities purchases, perhaps as early as this summer. Then, if all goes as hoped, we could end the purchase program sometime late this year." This was only slightly softer than his remarks on April 3: "[A]ssuming my economic forecast holds true, I expect we will meet the test for substantial improvement in the outlook for the labor market by this summer. If that happens, we could start tapering our purchases then. If all goes as hoped, we could end the purchase program sometime late this year."

Ultimately, however, it is the leadership whose signals will carry the most weight. We are therefore particularly focused on the upcoming testimony by Chairman Bernanke to the Joint Economic Committee of Congress on May 22. We expect a somewhat softer message than that from President Williams.

Q: Some commentators argue that the rapid decline in the federal budget deficit may prompt the Fed to taper earlier than they otherwise would have done. Do you agree with this?

A: No. This argument seems to be based on the implicit assumption that the purpose of the QE program is, at least partly, to finance the federal deficit. Fed officials would take strong exception to this notion. In fact, if we accept the notion that QE affects financial conditions and economic activity mainly via the stock of securities held, rather than the flow of issuance absorbed, there is no obvious link between the size of the deficit and the pace of asset purchases. A smaller deficit could call for a smaller QE program if it was mainly due to a stronger economy; but it could likewise call for a larger QE program if it was mainly due to greater fiscal drag. In practice, it is probably due to a combination of both factors, and we do not believe that it has substantial implications for Fed policy.

Q: So what could get Fed officials to increase the size of the QE program, either through a later beginning to the tapering process (say, March 2014) or a higher run rate of purchases?

A: Such a decision would probably be due to a combination of weaker job market data and lower inflation. We think that the hurdle for increasing the size of the purchase program is significantly higher. It would probably require either a clear downturn in the economy with a renewed risk of recession or a substantial decline in core PCE and CPI inflation as well as inflation expectations. But the hurdle for pushing out the date of the initial tapering may not be that high. If the labor market and economic recovery remained a little more sluggish than our forecast and underlying inflation trends moved any lower than the current 1¼% rate, we believe that the start date would move into 2014, with an announcement at the March meeting or later.

Q: Will they taper Treasury or mortgage QE first?

A: We think they will disproportionately taper the Treasury purchases, as there is a widespread belief that the stimulative per-dollar effect of MBS purchases is larger. According to the March FOMC minutes, “[a] few participants felt that MBS purchases provided more support to the economy than purchases of longer-term Treasury securities because they stimulated the housing sector directly.” Although the minutes also note that “a few preferred to focus any purchases in the Treasury market to avoid allocating credit to a specific sector of the economy,” the former group is likely to be closer to the views of the FOMC leadership.