Tapers (and pigs) will fly

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Regular readers will know that I’m suspicious of the “taper”. Today I get some support from a Westpac note that makes plenty of sense. Check out, for instance, the FOMC’s growth projections in the below chart. Tapers and pigs will fly and good job Westpac!

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In his semi-annual testimony to US House of Representatives Committee on Financial Services, Chair Bernanke highlighted a number of well-worn themes in an effort to again emphasise that any change in the Fed’s policy stance is conditional on the evolution of the economic outlook. Despite the familiar themes, there was most certainly a more dovish tone to the Chairman’s remarks.

We remain of the view that the market has got well ahead of itself on the tapering issue and that the Fed is most likely to continue its asset purchases at the current rate into 2014. Our anti-consensus view on this issue rests on our concerns over the frailty of the labour market and the housing recovery and the lack of momentum pass-through to other areas of end demand. It was constructive to see many of these points discussed by the Chairman.

In the prepared remarks and the Q&A, there was a notable focus on the housing market. The recovery seen over the past year was again highlighted, as was its importance to the labour market and other sectors. Chair Bernanke noted that he expected this recovery to continue, but that “it will be important to monitor developments in this sector carefully”.

As we have highlighted of late, there are very good reasons to remain cautious over the housing outlook. Outside of the ongoing difficulties accessing credit for those with less than optimal credit histories, the dramatic 120bp rise in the 30-yr mortgage rate to around 4.5% since late 2012 on tapering expectations is the prime concern.

We are yet to see what impact this will have on the prime housing market data. However, initial indications from mortgage applications data are concerning: on a 4-week moving average basis, purchase applications are 5% below their early May peak; more noticeable is that refinance applications have more than halved since peaking in October 2012. Overnight we also received very weak June outcomes for housing starts and building permits; both indicators posted substantial declines against market expectations of gains. If this weakness is confirmed by other housing data in coming months, FOMC asset purchase discussions could well shift from tapering to expansion (see below).

On the labour market, there was little new detail in the prepared remarks, other than a clear enunciation that it is the substance of the employment report that matters, as opposed to the headline outcomes. Specifically, Bernanke made it clear that the specific numerical target for unemployment (and inflation) is a threshold not a trigger, with rates potentially remaining very low after those outcomes were achieved. Bernanke also focused on the drivers of the unemployment rate, highlighting that the Fed wanted to see it decline due to jobs growth, not “cyclical declines in labour force participation”.

In the Q&A, Bernanke also commented that the Federal Reserve had heard that some employers refused to employ staff on a full-time basis owing to the potential obligations that it could see them incur under the new ‘Affordable Health Care’ Act. In the July Beige book (also released overnight), a similar point was raised, with firms seen as “cautious or reluctant to hire permanent or full-time staff in a number of districts”. It is quite possible that this preference for part-time and casual staff may be behind a significant portion of the nonfarm payrolls gains reported in recent months: almost half of the jobs created in the past three months have been in the leisure, hospitality and retail space; and, from the household survey, part-time jobs have outpaced full-time jobs six to one over that period.

The overall speech also emphasised the Fed’s other primary objective: 2% inflation on a PCE basis. While markets have tended to mainly focus on the state of the labour market, the Chairman has consistently noted the importance of inflation moving towards the 2% target. Whereas the official Fed forecasts for June showed a modest improvement in the outlook for unemployment relative to March, there was a marked change in the forecast for inflation. In March, the Fed forecast inflation in 2013 to be 1.3–1.7% (core 1.5–1.6%). In contrast, the June forecast was 0.8–1.2% (core 1.2–1.3%). In his testimony, inflation was noted by the Chairman to be currently running at 1%. Further, he emphasised the prospect that very low inflation poses risks to economic performance and increases the risk of outright deflation. He also noted that, even if the unemployment rate reached the 6.5% threshold, “the Committee would be unlikely to raise the funds rate if inflation remained persistently below our longer run objective”.

Focusing on the outlook for policy, Bernanke made it very clear that “if the outlook for employment were to become relatively less favourable, if inflation did not appear to be moving back toward 2%, or if financial conditions – which have tightened recently – were judged to be insufficiently accommodative to allow us to attain our mandated objectives” then the current pace of purchases could be maintained or indeed increased for a time. Clearly the Fed remains open to doing what is necessary to maintain its objective of a “return to full employment in a context of price stability”, whether that means tightening, easing, or maintaining its current stance.

It will be the strength of growth, the labour market and inflation data which collectively determines the outlook for policy and any potential tapering. Versus the FOMC’s expectation of growth of around 2.5% and 3.25% in 2013 and 2014 respectively, we expect growth around 1.6% in both years. Q2 growth (due out next week) is currently tracking closer to 1% than 2%, leaving annualised H1 2013 growth at 1.4%. The absence of end demand strength outside of durables consumption and new housing activity along with the troubling first response to higher rates in the housing market lead us to expect that the FOMC’s expectations will once again be disappointed, leaving the case for tapering anything but proven.

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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.