With Septeper an epic disappointment, some terms being casually thrown now include Octaper and Dectaper. But while the first is quite improbable, despite Bullard's attempt at a trial balloon floated on BBG TV moments ago, the prevailing consensus has now shifted to December. Which incidentally is when Bank of America, which was the only big/TBTF bank to correctly forecast a Snotaper announcement, has marked its calendar in expecting the first $10 billion reduction in the monthly $85 billion flow injection by the Fed. To wit: "In line with our out-of-consensus call, the Fed surprised most market participants and did not taper at their September meeting. Moreover, the FOMC statement, updated projections, and tone of Chairman Bernanke’s press conference all were dovish, as we had anticipated. Thus, our base case remains for a December taper. We now expect a modest-sized reduction of $10 bn, split evenly between MBS and Treasuries, followed by a gradual, data-dependent wind-down of purchases likely to end in October 2014. We also now expect the first rate hike in late 2015 at the earliest (previously we had looked for the first hike that summer), putting the target funds rate at 50 bp at the end of 2015 and 1.50% at the end of 2016."
Some more on Dectaper from BofA:
Hold the line
In line with our out-of-consensus call, the Fed surprised most market participants and did not taper at their September meeting. Moreover, the FOMC statement, updated projections, and tone of Chairman Bernanke’s press conference all were dovish, as we had anticipated. Thus, our base case remains for a December taper. We now expect a modest-sized reduction of $10 bn, split evenly between MBS and Treasuries, followed by a gradual, data-dependent wind-down of purchases likely to end in October 2014. We also now expect the first rate hike in late 2015 at the earliest (previously we had looked for the first hike that summer), putting the target funds rate at 50 bp at the end of 2015 and 1.50% at the end of 2016.
All of these projections, however, are necessarily conditional. As we explore below, the case for a December taper is not clear-cut. Indeed, our forecast is conditional on the data improving over the next several months, as well as better financial conditions and resolution of near-term fiscal uncertainties. Each of these has the potential to disappoint. As a result, we do see a significant risk that the Fed will not begin to taper until next year.
Just a little patience
Most of the commentary about why the Fed had to taper in September — the need to ratify market expectations, to preserve credibility, to acknowledge unspoken concerns about potential bubbles and QE efficacy, to smooth the transition to the next Fed chair — had little to do with the economic outlook. In contrast, the Committee “decided to await more evidence that progress will be sustained” before tapering. In his press conference, Chairman Bernanke stated that “the economic data do not yet provide sufficient confirmation” for reducing purchases.
Some commentators suggested Fed credibility was undermined by this decision, but we think otherwise: the Fed demonstrated that “data dependence” really does mean dependence on the data. Ultimately, this is a much more market-friendly message than “ratifying” tapering expectations, as it demonstrates that the Fed will continue to provide support for the recovery while it is needed. It also avoids an adverse feedback loop between the Fed and the markets that ultimately could be much more destabilizing. And despite some improvements since QE3 began, growth has not gained momentum (we are tracking 1.6% 3Q GDP growth), the broader labor market is still recovering, and inflation remains well below the Fed’s long-run target. There is still much to do.
Some commentators have wondered why the Fed couldn’t just taper a little: what, after all, is the big benefit of $85 bn over, say, $75 bn in monthly purchases? Yet one could easily turn the question around: what bubble or financial market disruption is being caused by $85 bn that just $75 bn in purchases would prevent? The past several FOMC minutes reveal that relatively few Fed officials are concerned that the benefits of QE might exceed the costs, and even fewer of those are voters. The decision on when to taper will stand or fall on the data and how it influences the economic outlook at that point.
When September ends
So what would it take to get the Fed to taper in December? Chairman Bernanke said that “the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective.” Thus we look at both the labor market and inflation to see what conditions might satisfy those expectations. As the FOMC singled out “tightening of financial conditions” as another concern, we look at those as well.
A “substantial” improvement in the labor market outlook has been the stated goal for QE3 by the Committee. In his press conference, Bernanke suggested at one point that “significant” progress has been made. The difference between these two is not very clear and probably not very great. Indeed, we expect the minutes to review a very closely divided Committee over progress in the labor market; it likely was a close call for the voting members.
That said, we learned that the Fed will be de-emphasizing the unemployment rate going forward. We had always been a little surprised that the Fed put an unemployment threshold front and center, as it appeared abundantly clear back in December 2012, when first announced, that the unemployment rate had been dropping for the wrong reasons — namely, a drop in the participation rate (Chart 1). In the press conference, Bernanke acknowledged that because of this, the unemployment rate “understates” the true situation.
Hence, not only is the Fed likely to hike rates only well after the unemployment rate crosses 6.5%, but there was no mention of 7% as an indicator of when the Fed would likely end QE3. The fact that the unemployment rate is falling faster than anticipated will not accelerate the size or timing of tapering.
Second, the pace of employment growth needs to rebound. As Chart 2 shows, the July and August non-farm payrolls are an even bigger disappointment once revisions are included, and the 3- and 6-month averages suggest a real drop in momentum. The Fed needs to be convinced that the labor market is making steady, sustainable improvement before they are likely to taper. While the FOMC does not have a specific threshold, our interpretation of various Fed officials’ speeches is that job growth in the 175,000 to 200,000 range would be the bare minimum; they likely would need to see other employment data (share of parttime, median duration, number of long-term unemployed) improve as well.
Figuring out financial conditions
The biggest challenge for Fed officials is communicating how financial conditions enter into their decision to taper. Although some of the regional Fed banks publish measures of financial conditions or financial stress (for example, Chart 4), there is no standard measure that is easy for the Fed and the public to reference. Indeed, the Chicago Fed’s conditions measure has worsened a bit recently, while the Cleveland Fed’s stress index has actually improved. This likely reflects the fact that, whatever negative impact higher rates may have had on interestsensitive sectors, they also appear to have helped to remove some of the froth in selected areas of the capital markets.
Some analysts have suggested that, in fact, was part of the plan: that the Fed was secretly worried about potential bubbles and sources of financial instability, and talked up interest rates with the express intent of bringing them back down once the froth was gone. Setting aside the fact that Fed officials seem genuinely concerned about higher mortgage rates and the potential slowdown in housing activity — they mention it right in the statement — that view implies an implausible amount of influence over longer-term interest rates by the Fed. If they really had that much influence, why not just peg long rates outright until the recovery measurably improves?
Others say that the Fed gave tacit approval of the run-up in rates. This perception was compounded by the silence of key Fed members of the Fed leadership over the past few months — and it is hard to hear what isn’t said. Nonetheless, this view runs counter to the fact that Fed started talking nervously about tighter financial conditions back in July, when 10-year yields were in the 2.50 to 2.60% range. But as Bernanke noted rather emphatically at the press conference, “We can’t let market expectations dictate our policy actions. Our policy actions have to be determined by our best assessment of what’s needed for the economy.”
On that issue, there is little doubt that higher interest rates could harm the economy, and as we noted in this space a few weeks back, softness in some housing and capital spending data may suggest some damage has already occurred. What we don’t know is what the Fed is looking at to determine the adverse impact of higher rates. This is something that the many Fed speakers over the next week could helpfully clarify.
Finally, some market participants worry that if the Fed is unwilling to taper when rates go up, it will never taper. But that isn’t what the Fed has said. As Bernanke noted, the Fed is comfortable with higher rates that reflect faster growth, higher income, and broader activity. Early in the recent tightening of financial conditions, the Fed was able to convince itself that a decent share of the rise in interest rates reflected exactly that. But as growth faltered while rates continued to climb, the Fed became far less comfortable. In the end, the Fed is trying to manage a gradual normalization of policy, and thus of rates, as the economy heals. Not surprisingly, the markets are focused on the destination — are we there yet?