Here Comes the Taper
TheFinanciaList: If you’re not a little tired of the will-they-won’t-they discussions surrounding the Federal Reserve’s expected decision to start pulling back on its $85 billion in monthly asset purchases, consider yourself lucky. Though headlines are abuzz about when the central bank might finally announce tapering, market participants seem to have gotten wise to a more important reality: An interest rate hike isn’t likely anytime soon. The taper, whenever it comes, may yet prove to be a little anti-climactic.
Though Federal Reserve Chairman Ben Bernanke first hinted the central bank could begin reducing asset purchases soon in testimony before Congress in May, markets didn’t fully react until June, when he said the same thing at a press conference. The Dow Jones Industrial Average fell 4.3 percent over four trading sessions following that briefing, while the S&P 500 fell nearly 5 percent. Emerging markets took a particularly tough hit, as fleeing investors put pressure on currencies from the Indian rupee to the Brazilian real.
Those first warning shots in May and June turned out to be a head-fake. Stock markets recovered quickly after the June swoon, and investors have gradually returned to emerging markets. But the stronger-than-expected jobs report last Friday seems to have set the stage for central bankers to announce a pullback in quantitative easing either at the Dec. 17-18 Federal Open Market Committee meeting or in January. After all, the economy added 203,000 jobs in November – well above the consensus estimate of 185,000 – and unemployment fell from 7.3 percent to 7 percent. That’s exactly the level at which Federal Reserve Chairman Ben Bernanke suggested back in June that quantitative easing could end altogether. He may regret uttering those words, but it’s a pretty good indication that the bank is itching to get out of the bond-buying business as soon as the economy is stable enough.
So, did fear-addled markets panic in response to that strong jobs report? Nope. Both the S&P 500 and the Dow Jones Industrial Average rose a bit on Friday, in fact, though they have pulled back some since then. The reason for the apparent nonchalance, Credit Suisse economists Neal Soss and Dana Saporta write in a recent note called “FOMC Meeting Preview: It’s Just a Matter of Time,” could be that market participants “may be starting to understand that tapering does not imply a change in the Fed’s overall accommodative policy stance.”
In fact, the central bank is likely to remain supportive, the economists point out. The Fed is well aware that last month’s jobs numbers and 7 percent unemployment rate hide some worrying information. Sure, central bank liquidity has helped stock markets soar this year. And yes, unemployment is down from 8.1 percent, where it was when the Fed first announced QE3 in September 2012. But you can only credit 30 percent of that 1.1-percentage-point drop to more people gaining employment – the rest is due to a shrinking labor force. Hiring rates and the number of people quitting their jobs – something typically reserved for lottery winners, those who have something else lined up or those who are confident about their ability to land alternative employment – have ticked up a little in recent years, but they’re still not as high as they were before the Great Recession. And as for the 3.6 percent GDP growth the U.S. enjoyed in the third quarter? Well, about half of it can be chalked up to businesses building up their inventories. This is not to say the economy isn’t getting stronger – things are indeed moving in the right direction, Credit Suisse economists Neal Soss and Jay Feldman conclude in a recent report called “Jobs Review: What Do the Yellen Indicators Tell Us?” But it’s going too far to say the economy is showing signs of brute strength.
Because of that, reassuring market participants that interest rates will remain low – even though the 6.5 percent unemployment rate threshold for raising rates appears within reach much sooner than expected – is critically important. In their note, Saporta and Soss review five methods Fed officials have discussed for making clear that rates will remain low, a message that is key to achieving what they call a “dovish taper.”
Issuing more explicit guidance is one option: The Fed could simply tell markets exactly what would happen to the funds rate after the economy achieves either of the central bank’s thresholds for a rate hike (6.5 percent unemployment or inflation above 2.5 percent). Alternatively, central bankers could establish a standing facility for buying shorter-term Treasury bonds to keep yields in check. Finally, in a move that Saporta and Soss believe is possible “down the road,” the Fed could simply cut the interest rate paid on excess reserves (IOER) that banks deposit at the central bank. The Fed is already testing a reverse-repurchase agreement facility that could help prevent some of the money-market disruptions an IOER cut might otherwise cause.
But it may be easiest simply to move the goalposts. Rather than knocking down the unemployment threshold, Saporta and Soss say “the best method to deliver a dovish taper would be to define a lower boundary for the inflation outlook, say 1.5 percent, below which the FOMC would be unlikely to tighten policy, no matter where the unemployment rate happens to be at the time.” After all, since the shrinking of the labor force is doing most of the work in driving the unemployment rate lower, October’s 1 percent annual inflation rate is a better window into the state of the real economy. The view isn’t entirely pretty. So, even if officials pull the trigger on the taper next week, they will surely be doing everything possible to reassure markets that, more broadly, central bank support isn’t going anywhere. When one story ends, another begins.
By: