Is the Fed taper debate off the agenda for 2013?

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ScreenHunter_08 Mar. 19 11.54

From Elliott Clarke at Westpac comes the below neat summation of last night’s decision by the Federal Reserve not to wind-back (“taper”) its $US85 billion a month of bond purchases:

Ahead of the September FOMC meeting, we maintained our position that the macroeconomic conditions apparent in the US economy did not warrant tapering. Specifically, despite the unemployment rate continuing to decline, overall labour market conditions remained weak. Further, growth remained sub-par, and it was not at all clear whether the fiscal drag so often mentioned by the Fed would dissipate in the second half (as they had expected). We went on to highlight that, should the FOMC be forced to taper owing to market expectations, that their forward guidance would have to be loosened – the net effect on the stance of policy being at worst neutral, depending on whether you view tapering as contractionary or not (we do, the Fed is arguably uncertain).

With market expectations so firmly focussed on tapering, our “compromise” call was a token taper ($5bn), with a substantial strengthening of guidance which would make it very clear to markets that a Fed tightening could not be expected until well into 2015. With Professor Summers now out of the “succession” picture, this package of decisions would see interest rates fall markedly across the curve – particularly in the short end as the timing of tightening expectations was pushed back.

Overnight, the FOMC surprised the market even more than we had expected, deciding “to await more evidence that progress will be sustained before adjusting the pace of its purchases”. The meeting statement went on to note that “Asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s economic outlook as well as its assessment of the likely efficacy and costs of such purchases”. And, “In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments“.

Taken together, these statements show the Fed is taking a holistic view of both the labour market and the broader economy. Further, there is a clear emphasis on the importance of financial conditions and their impact on growth. This latter point was given further support by Chair Bernanke in the subsequent press conference. Specifically, Bernanke noted “the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and the labor market”. Clearly, while the committee is undecided on the contractionary nature of tapering, they are firmly of the view that the flow-on effects on financial conditions are impinging on economic momentum. The Fed is clearly intent on seeing interest rates lower across the curve, including the long end where the most sensitivity to the housing market lies.

Bernanke also provided a more open view on the potential longevity of the fiscal drag on growth, noting “the extent of the effects of restrictive fiscal policies remains unclear, and upcoming fiscal debates may involve additional risks to financial markets and to the broader economy”. The reference to fiscal policy is obviously not only talking about the already legislated tightening (which we expect will continue to impact the economy through 2013 H2 and into 2014), but also the potential effect of the upcoming debt ceiling debate in late October, on confidence and potentially via a further sequester.

Given the apparent concerns over the holistic health of the labour market and the underlying growth pace, the revisions to the FOMC’s forecasts should not have been a surprise to the market. The FOMC’s central tendency forecast for GDP growth has been revised down from 2.3–2.6% to 2.0–2.3% for 2013, and from 3.0–3.5% to 2.9–3.1% for 2014. The FOMC sees growth in 2015 and 2016 a little above 3.0%.

But it is arguably not the growth forecasts but rather the inflation and fed funds rate forecasts which give a better guide on policy in this instance. Specifically, the FOMC does not expect to reach its inflation objective (2%) before the end of 2016; this suggests the Fed sees a great deal of slack remaining in the economy through the forecast period. Consequently, the Fed funds rate is only expected to be raised first in 2015 (by 12 of 17 members) and to only reach 2% by the end of 2016 (middle of forecast range). This is a decidedly more dovish profile than many would have expected. But it is very much in keeping with our expectation that the US economy will continue to struggle to grow at an above-trend pace.

So what does today’s decision mean for the near-term outlook for policy? Put simply, Chair Bernanke has gone out of his way to highlight that any tapering will be data dependent and that there are no specific numerical triggers. Indeed, in the Q&A, Bernanke clearly stated that the 7% end-taper “target” was an example of a meaningful improvement in the labour market and no more; further, that the 6.5% unemployment rate target for the beginning of the rate normalisation process was only a threshold for considering rate increases and it was likely that rates would not be raised until the unemployment rate was markedly below 6.5%. Note that current forecast for the unemployment rate by end 2015 is 5.9–6.2%.

It is also important to note that, if as we suspect Q3 growth comes in at 1.7% annualised, we would need to see a 3.3% Q4 outcome to achieve the FOMC’s new growth forecast. From our perspective it will therefore be necessary for the Fed to again lower its 2013 and 2014 growth forecasts at the December 17/18 meeting. Coupled with the likely turbulence emanating from Washington in October, a near-term taper now seems like a highly unlikely proposition.

Tapering looks to be off the agenda, at least for 2013.

About the author
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.