Tapering is set in stone

Advertisement
imgres

Fresh from Elliot Clarke at Westpac:

Hindsight reveals many interesting nuances often hidden in real time by pre-conceived perceptions and omitted information. When considering the path policy makers will take, it is not only necessary to minimise the effect of both on your own perspective, but also to effectively step into the shoes of policy makers – their cognitive biases (i.e. enduring optimism over the outlook) included.

With regards to tapering, last December our position was simple: owing to the structural ill health of the US economy, it was prudent to persist with QE until such time as domestic final demand growth was at or above trend. To us, with inflation benign, broad labour market conditions still fragile (best represented by the historically-low employment to population ratio and weak participation amongst prime-aged workers, i.e. 54 or younger) and next-to-no evidence of the excess reserves of banks being put to work, there was little cause to be concerned about the economy overheating from extended liquidity provision.

As time has borne out, this ‘hard line’ on structural concerns was clearly incorrect, not because the economy has outperformed our expectations (see below), but instead owing to the cognitive biases of the FOMC. What we mean by this is simply that, for a group that persistently anticipates a prompt return to trend growth (or above) and full employment, the concept of open-ended liquidity provision is a hard pill to swallow. Arguably, with hindsight, the initial decision to not define a time period or total amount of easing was a mistake, one that had to be corrected. As swift an end to QE3 as possible without causing the economy to falter was always the FOMC’s plan, with the Committee prepared to compromise on their growth and inflation targets in the near term.

To this end, we now believe that the tapering process will run its course before year’s end, and are targeting a final reduction of $15bn at the 28–29 October meeting – there seems little reason to expect $5bn to be held back to December. The crucial question then becomes, where to for interest rates, both with respect to a subsequent normalisation of the Fed Funds rate and the level of term interest rates? The actual and perceived prospects for aggregate growth and household wealth matter a great deal.

On growth, the market continues to focus upon headline outcomes. In doing so, the particularly poor Q1 outcome of 0.1% annualised is a material step down from the growth outcomes of H2 2014 (4.1% and 2.6% annualised for Q3 and Q4 respectively), albeit one that can be easily blamed on the weather. From our perspective, what really matters for the policy outlook is the pace of domestic final demand, our proxy for underlying demand. This remained sub-trend at 1.6% through 2013, about half the pace it averaged during the 20 years that proceeded the GFC recession, and also printed at 1.5% annualised in Q1 2014. Herein we see an economy which remains stuck in a endogenous low-growth loop, hamstrung by an absence of real household income growth, enduring legacy liabilities and a highly unequal distribution of wealth – for more on the latter topic, see Northern Exposure 11 April and 17 April. Our expectation is that domestic final demand growth will remain sub-trend through 2014 before accelerating towards 3.0% in 2015.

In the short-term then, there is enough underlying momentum to withstand an end to tapering, but not materially higher term interest rates or a reduction in the balance sheet. This is arguably truer of the housing market for which the likely duration and scale of any investment means the price of funds matters a great deal more. For those who doubt this interest rate sensitivity, consider what has happened to the housing market since the middle of last year (well before the recent weather), most notably to refinancing mortgage approvals which are back near their GFC lows. (An aside on wealth: an end to marginal liquidity provision should not, of itself, cause asset prices to fall, but it is a risk; should we see a material fall, the FOMC would be forced to rethink its plans.)

If the FOMC can keep term rate expectations benign by focusing on the still-apparent economic slack and the highly data-dependent nature of the normalisation process, then not only can tapering be completed without causing near-recessionary conditions or a major market impact, but there may also be room for a limited number of increases in the Fed Funds rate (we believe from late 2015). This would bring about a partial normalisation of short-term rates and, as consequence, policy flexibility for the future.

This is not to say that the growth and inflation expectations of the FOMC will be achieved in 2014, or 2015 for that matter; to do so would require a much greater degree of stimulus to the real economy, something the FOMC is unwilling (or arguably given the scale of bank excess reserves) unable to provide. The FOMC is walking a fine line: conditions allow for accommodation to be reduced; but the economy remains highly sensitive to another rate-induced economic shock. Policy rate expectations and the associated impact on term rates will bear careful watching hence.

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.