News in Charts: Approaching the Taper

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Officials at the US Federal Reserve have communicated clearly their desire to initiate the tapering process soon – in Minutes of regular meetings, as well as in a number of set-piece speeches. The macro-economic data, particularly with regards to GDP and to the labour market, have turned out stronger than might have been expected a few months ago, and in the main have been supportive of an early end to the period of exceptionally loose monetary policy. But the inflation data, though clearly a lagging indicator of economic activity, continue to disappoint. As we set out below, we continue to expect an initial reduction in the pace of asset purchases during the early part of next year, not least because the collective view among Committee members appears to be that we are nearing the point where the risks inherent in continuing the programme start to outweigh the benefits. The big unknown, of course, is whether the centre of gravity on the Committee might shift when – subject to next week’s Senate vote – Janet Yellen replaces Ben Bernanke as Chair.

Concerns that the fiscal tightening implemented in stages early this year might have derailed the US recovery have come to nought. Activity has picked up through the year, with growth coming in at 3.6% in Q3. Although we are yet to see the full impact of October’s temporary Federal government shutdown on the Q4 data, the FOMC will take comfort from the fact that the bi-partisan deal struck earlier this week effectively rules out a repeat of this charade for at least the next year. Our own forecast is that the US will continue to lead the way among the major economies through 2014, with growth of 3.3% through the year as a whole.

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The picture on employment is one of steady improvement. After dipping slightly through the summer, monthly payrolls are now averaging a healthy 200k. From a low point in early 2010, private sector payrolls have seen steady expansion in the face of the government’s austerity drive which has seen public sector payrolls fall. As St Louis Fed president Bullard said this week, the “cumulative progress of the labour market since September 2012 provides the most powerful part of the case for tapering…based on labour data alone, the probability of a reduction in the pace of asset purchases has increased”. Mr Bullard will cease to be a voting member when Mr Bernanke steps down on 1 February 2014.

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In terms of the macro-economic data, one major source of concern remains the picture on inflation. The PCE deflator rose by 0.7% in the twelve months to October, and that is well outside the Fed’s comfort zone. The threat of deflation is arguably more pronounced now than at any time since August 2010, when Mr Bernanke first hinted at the need for QE2. Ms Yellen is a strong believer in the power of QE. In a speech back in 2011, she highlighted Fed research which suggested that, at the time, the LSAP programme had boosted inflation by a percentage point and would eventually add 3 million jobs to the US economy. It is possible that she may wish to see core inflation nearer 2% than 1% before voting to taper. It is also fair to say that indicators other than the headline measure of unemployment continue to point to a substantial degree of labour market slack – the U-6 measure, for example, which counts discouraged workers, those who are described as marginally attached, and those working part-time who would prefer to work full-time in addition to the unemployed, rose sharply as the recession hit. The gap between the broader U-6 measure, sometimes referred to as a measure of ‘underemployment’, and headline unemployment has yet to close in any meaningful sense.

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But there is not just the macro-economic data to think about. FOMC members appear, collectively, to have become increasingly concerned that unlimited expansion of the balance sheet of the Federal Reserve is leading to undesirable movements in asset prices. There appears to be a growing conviction among FOMC members that, in the words of Dallas Fed president Fisher, who becomes a voting member in 2014, additional QE “comes at a cost that far exceeds its purported benefits”. Even Chairman Bernanke has recently acknowledged that the net benefit to further QE is questionable: “we are somewhat less certain about the magnitudes of the effects on financial conditions and the economy of changes in the pace of purchases…including the risk of impairing the functioning of securities markets and the extra complexities for the Fed of operating with a much larger balance sheet”, he said in a recent speech.

The FOMC, in its current composition, has become increasingly keen to taper. In the latest set of Minutes, it was acknowledged that tapering may be necessary “even before an unambiguous further improvement in the outlook was apparent”. Although it can be argued that the budget deal agreed this week, by removing one of the obstacles that may have caused Committee members to back off in September, leaves the door to tapering as early as this month ajar, our view remains that it will instead begin in the early part of next year.

Undoubtedly, the picture on inflation complicates things. But if the net benefit to further QE is openly referred to as negative, then will shying away from tapering really help matters? And if consecutive rounds of QE, that together amount to almost one quarter of US GDP, have failed to stem the decline in inflation, then how effective would it be to continue along the same path? These are difficult questions and the answers are far from clear cut. Our sense is that, on the one hand, there are lags in the transmission of monetary policy – particularly in the aftermath of a severe financial crisis – while, on the other, the impact of QE on financial markets has arguably dwarfed any direct effect it has had on the real economy.

Furthermore, the path toward a greater emphasis on forward guidance – the Fed’s “stronger, more reliable” tool according to Mr Bernanke – is itself fraught with uncertainty. This is why the FOMC is looking to be ready to hedge the taper through a range of potential instruments intended to enhance the message of “low for longer”; after all, as we recently pointed out in our Monetary Policy Round-up, according to our Taylor Rule the policy rate in the US should be close to zero at the moment. Yet, this constitutes a further push into uncharted territory and, as such, it remains to be seen whether disentangling asset purchases from forward guidance in investors’ minds can successfully morph into a concrete policy toolbox going forward.

So far, the combination of a steepening yield curve with falling short-term Treasury yields suggests that markets have taken the Fed’s guidance on board. Investors appear to have “moved on”, more or less fully discounting the initiation of tapering: the 10-year Treasury yield shrugged off November’s strong employment report and US equities have broken to record highs despite relatively weak corporate earnings expansion.

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At the same time, US equity investors have been betting on prospects for future growth throughout the latter part of this year, as our chart below illustrates. As such, we have arguably reached a point where any postponement to the taper beyond the early part of 2014 will more likely than not be perceived in negative terms by the market. In a sense, it is almost as if investors are actively refraining from scaring the Fed away – in contrast to what happened during the summer.

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