Markets have reacted pretty intensely in recent weeks with respect to the next policy steps by the Federal Reserve. ‘Tapering’, the latest buzz word in financial markets, used to refer to a (possible) cut back in bond purchases by the central bank, has taken center stage. But how likely is this bond tapering and what does it say about the interest rate policy? With the FOMC meeting due on Wednesday let’s look at some of the facts.
What Bernanke said
“If we see continued improvement and we have confidence that that is going to be sustained, then …– in the next few meetings, we could take a step down in our pace of purchases.” This was an off-hand comment during Bernanke’s May 22 Congressional testimony, which got things really going in the markets. Surrounding this statement other Fed-members talked about a possible scaling back of the bond program as well.
But the fact that Fed-members are openly discussing the gradual scaling back of any quantitative measure should not be surprising. They are referred to as ‘unconventional’ for a reason. This implicates that central bankers will have the urge to end any of these measures if possible.
Let’s go back to the May 22 testimony. Bernanke had more interesting things to say than only the statement above. Here are two other interesting quotes from that speech: “I want to be very clear that a step to reduce the flow of purchases would not be an automatic mechanistic process of ending the program. Rather, any change in the flow of purchases would depend on the incoming data and our assessment of how the labor market and inflation are evolving.”
“Again, if we do that, it would not mean that we are automatically aiming toward a complete wind-down. Rather, we would be looking to beyond that to see how the economy evolves, and we could either raise or lower our pace of purchases going forward.”
So, although it is very clear that the Fed is looking for a way out, for a proper strategy to reduce some or all of the unconventional measures, the decision is very much dependent on macro-economic data.
Dependent on incoming macro data
At the March press conference Bernanke stated that “the purpose of the asset purchases is to increase the economy’s near-term momentum, with the goal of improving the outlook for the labor market and helping to promote a self-sustaining recovery with price stability.” In the official FOMC statement the Fed translated this into tangible goals. The FOMC stated that the exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.
Let’s take a look at these macro factors. The graph below shows the development of the Core PCE index, the Fed’s preferred measure of inflation. I also depicted the regular Core CPI as calculated by the Bureau of Labor Statistics. Both inflation gauges move in the same direction, down and are not even close to a half percent point above the longer-run goal. If anything, inflation is too low.
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The next graph plots the official employment rate together with the rate of people that are outside the labor force, hence do not show up in the unemployment rate, but do want a job. That rate, which involves marginally attached workers (and discouraged workers), is still relatively high. It is not by accident that Bloomberg has added the so-called U-6 Unemployment rate, a proxy for total unemployment, which takes into account people outside the labor force, to its Economic Calendar (WECO US).
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The Fed will take this broader unemployment statistic into consideration even when the official unemployment rate hits the 6.5% goal. Which, by the way is not likely to happen anytime soon with current unemployment at 7.6% and the change in the nonfarm payrolls well under 200k for the last three consecutive months. Add an ISM Manufacturing below 50 and, although things have improved, there is still some work to be done.
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Tapering and higher interest rates are two different things
I expect that this could well be the central theme in Bernanke’s speech on the FOMC decision on Wednesday. The tapering of the bond purchases is by no means an indication that rates will rise anytime soon. Yet, this is what at least some investors have been anticipating.
The Fed has been struggling with its communication, especially on this matter. With all the discussions going on, markets seem not convinced that changes in monetary policy are not necessarily one-way and that tapering does not mean hiking rates. JP Morgan stated recently that, since the beginning of May, the market has pulled in expectations of the first rate hike by more than six months!
However, for the Fed tapering and rate hikes are very different. They see bond tapering as a minor technical move used to slow the, still very fast, pace of easing, which again will only happen if the incoming data allows it.
What to expect
Given the facts summarized above I expect the Fed to make a clear distinction between potential bond tapering and the interest rate policy. Given the recent weakness in macro-economic data and the benign inflation environment, Bernanke will probably not announce any immediate reduction in bond purchases, but at the same time will keep the option open for later this year. Furthermore, the main focus of Bernanke’s speech will probably be on the Fed’s intent to keep rates low for an extended period, pushing back the expectations for the first rate hike.