Tapering will be on the table at this week’s FOMC meeting, but will the Fed take the first step to ending the asset purchase program or let it ride into the new year? Wall Street analysts, economists, and pundits are all over the map on the tapering question, via Supeed Reddy at the Wall Street Journal. My own position is that while the Fed wants to taper, they will pass on this opportunity – although I admit I don’t hold that position with any great conviction. The data flow in my opinion, is rather ambiguous in regards to tapering. Given that ambiguity, other factors will comes into play. One factor is the potential for disrupting bond markets during a traditionally illiquid month. We know from this summer’s experience that the Federal Reserve is very sensitive to market functioning. Another factor is the institutional shake-up underway at the Fed. There is a potential continuity risk in changing policy now given the number of new faces among the voting members next year. In the absence of a dire rush to taper, it is reasonable to think the Fed will defer judgement until the crop of officials who will actually be carrying out the asset purchase wind down are all seated at the table.
Regarding the ambiguity of the data, I am hard-pressed to say that the economy has changed radically since September. To be sure, the employment data is arguably firmer, but this really speaks more to the tendency of Fed officials to be overly sensitive to the last data point than any real change in the underlying pace of activity. Compare the 12-month and 3-month trends in nonfarm payroll growth:
Job growth has been cycling around the 180-200k mark for 2 years. And even that cycle is suspect, partly an artifact of the impact of the recession on the seasonal adjustment procedures. Those impacts may be lessening (as they should over time) as indicated by the smaller fluctuations around the 12-month average. In short, the Fed has tended to define “stronger and sustainable” on the basis of the last two or three months of data, which thus opens the door again to tapering. It seem, however, that looking at the underlying trend the job market is neither more nor less “stronger and sustainable” now than any other time in the last two years.
Beyond employment data, broad industrial activity is rising at a relatively tepid pace:
Seems to be bouncing around 3% year-over-year. Nothing to suggest a dramatic change in pace since 2011. If anything, perhaps a bit weaker. As far as household spending is concerned, consider growth of retail sales excluding volatile auto and gasoline components:
Growth seems to have settled into the 4% year-over-year range. Broad household spending after inflation has also settled into a pattern of tepid growth:
Likewise, if you think of underlying growth as close to the average of GDP and GDI growth, that too is reasonably stable:
If you take anything but the most near-term look at the data, there is little to suggest much has changed one way or another. It’s no real surprise that the Beige Book continues to describe activity as “modest to moderate.” Move alone, nothing to see here, folks. But if monetary policymakers focus on the most recent few months of data, then they can argue that what they are seeing is “stronger and sustainable.”
Where they might see more promise is that the forecast for fiscal policy in 2014 is brighter. The budget deal is consistent with reduced fiscal drag next year while eliminating the possibility of another budget crisis. Indeed, I think a good story can be told that 2014 is an inflection point for economic activity. Still, we have told that story before, and with that lessen in mind it seems too early to declare “sustainable” without some actual 2014 data to work with. Where the Fed might find more traction is with beginning tapering on the basis of progress toward goals with a focus on unemployment:
That said, if one of the goals is price stability, that pesky dual mandate thing is rearing its ugly head with the falling inflation numbers:
I would say the Fed needs to abandon low-inflation concerns if they taper with these numbers, instead falling back on stable inflation expectations and a forecast of rising inflation. That forecast, however, really hasn’t worked out yet.
Overall, “stronger and sustainable” and “progress toward goals” are in the eye’s of the beholder. Same too with “progress toward goals.” It depends the goal. No wonder then that Fed officials appear so ridiculously noncommittal with regards to tapering. And no wonder then that market participants are also noncommittal over the outcome of this next meeting.
Given that ambiguity, the Fed may have a difficult time communicating any policy changes. Does the tiny taper suggest a more hawkish Fed considering the path of inflation? Or a more dovish Fed considering the path of unemployment? With no strong market expectations, the Fed may worry that any action they take would be misinterpreted in the thin holiday trading. Perhaps they believe that Federal Reserve Chairman Ben Bernanke could smooth out any issues during the press conference, but there is no certainty in that prediction. It’s not like he cleared much up with the June press conference. The importance of communication is even more important given that the nature of tapering itself is on the table – no longer are we guaranteed a data-dependent policy as the calendar-dependent suggestion is on the table. Hence there is a good case to be made for leaving policy broadly unchanged with the exception of modification to the forward guidance while setting the stage for a policy shift next year.
Finally, another reason to hold policy steady is the institutional changes raining down on the Federal Reserve. Next year we see a new chair, and new vice chair, a new governor, a new president, and a change in the FOMC that brings two hawkish voices into voting positions. Presumably, policymakers should be concerned that the policies they enact today will be consistent with the desires of the policymakers of two months from now. This is especially the case when policy is at an inflection point as it is now. In the absence of pressing need, it is thus easy to make the case that policy changes should be deferred to the next group of policymakers. Now, clearly the Fed would not let such an issue dissuade it from acting during a financial crisis, or in the face of incipient inflation risks. But neither of those are on the table right now, so there is no pressing need to act. Of course, some might argue that given the impending changes, this is this Fed’s last opportunity to leave its mark on policy – completely the opposite conclusion. More ambiguity.
Bottom Line: Unless you are living in a cave, you shouldn’t be surprised if the Fed decides to taper this week. At the same time, you shouldn’t be surprised if they do not taper. Even if they don’t at this meeting, they soon will.
This piece is cross-posted from Tim Duy’s Fed Watch with permission.