Chairman Bernanke’s legacy

From Elliott Clark at Westpac:

Last week we outlined why we felt a no taper decision was appropriate for the US economy. For us, the lack of a material pick-up in payrolls from their 2012 pace, weak job growth in the household survey, concerns over the participation of younger cohorts, soft domestic end demand, and inflation near historic lows collectively gave very good justification to stay the course in the hope that momentum would surprise and build through 2014.

In the event, Chair Bernanke and the FOMC instead decided to make an initial step towards normalising policy, reducing the monthly purchase rate of MBS and US Treasury securities by $5bn each to $35bn and $40bn respectively. The decision was based on the cumulative improvement in the labour market (i.e. continued payrolls job gains and the declining unemployment rate) and the Committee seeing the “risks to the outlook for the economy and the labor market as having become more nearly balanced”.

As we have long expected, the decision to taper came with an offsetting loosening of their forward guidance. Specifically, the “Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal”. On inflation, they also added that the “Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term”. The importance of qualifying the unemployment rate as the defining measure of the state of the labour market was further emphasised in the Chair’s press conference where he referred to other measures: the hiring rate; the quit rate; vacancies; underemployment; long-term unemployment; the participation rate; and wages growth. Particularly under the new Chair, these supplementary measures of the labour market will influence policy.

Herein we see the Fed seeking to characterise QE as being only one of the monetary policy tools to hand and that the normalisation path will be slow and long. To that end, it is not surprising that the FOMC continued to emphasise that “asset purchases are not on a preset course” and that the Committee’s decisions are dependent on the outlook for the labour market and inflation as well as “the likely efficacy and costs of such purchases”. This is arguably why December was chosen as the initial taper date as opposed to January: the December FOMC meeting is not Chair Bernanke’s last, but it is the last meeting followed by a press conference and forecast update.

The ability to offset the decision to taper with looser forward guidance is, to a large extent, dependent on clear communication which is well supported by the accompanying forecasts and Q&A. Specifically on the latter, Chair Bernanke was able to re-emphasise the data dependent nature of the tapering process, and also that historically low inflation remains a key concern – one that they may indeed act on in the future.

Based on the Q&A following the decision, the FOMC’s intention is to continue to reduce the purchase pace by $10bn at each meeting, meaning an end to QE in late 2014. This is backed by their expectations of growth of around 3.0% in 2014 and 3.2% in 2015 and that inflation will, with time, return to target. Should the economy disappoint, as we suspect, then the tapering process will be paused. Chair Bernanke was quite insistent that, just as the beginning of the tapering process was data dependent, so would be the future path.

Our expectation for sub-consensus growth in 2014 is well known, as are our concerns over the structural, long-term health of the US economy. Despite this, we recognise the FOMC’s near-term position on this issue. Accordingly we anticipate a further reduction in the pace of purchases at the January meeting, taking the monthly purchase pace to around $65bn. After this, we expect that the apparent lack of acceleration in the US economy will force the FOMC to pause tapering and, potentially, see purchases increased once again in mid-to-late 2014.

There will be an early test of this scenario with the release of Q4 GDP a day after the January meeting. Current FOMC estimates for 2013 growth imply a Q4 print of 1.6%, whereas we anticipate that slower inventory building than Q3 could see Q4 growth around zero. This implies that the FOMC’s growth estimates for 2013 and the likely momentum into 2014 were significantly overstated at the December meeting.

The other risks around this view are many, but there are a few key points that bear close watching. On the anti-taper front: we have already seen higher mortgage rates have a material impact on mortgage approvals, emphasising the risk of tapering to the housing market. In contrast, potentially further supporting tapering, the reclassification of unemployed who have lost their access to benefits as not in the labour force could see a sub-7% unemployment rate early in 2014.

Chair Bernanke and the FOMC’s actions overnight will define his legacy. If, as the FOMC anticipates, activity accelerates in 2014, then he will be able to lay claim to steering the US out of its worst crisis since the Great Depression. However, if our own expectations prove correct and activity disappoints, then questions will be raised as to why the FOMC was unwilling to allow the economy to gain traction, even after so many years of disappointing outcomes and historically weak inflation. Only time will tell.