The Week in Fiscal and Monetary Policy

The financial markets were more than a bit confused by the minutes of the April 30 – May 1 Federal Open Market Committee meeting. Some Fed officials wanted to begin tapering the rate of asset purchases as early as June. However, that wasn’t a majority opinion. Fed Chairman Bernanke’s testimony to the Joint Economic Committee of Congress was balanced, but strongly suggested that monetary policy is unlikely to be tightened anytime soon. In his testimony, Bernanke also lectured congress on fiscal policy, which has been completely wrong-footed this year. Additionally, with little fanfare, the federal debt ceiling went back into effect, but it’s not expected to be binding until sometime after Labor Day.

“Participants touched on the conditions under which it might be appropriate to change the pace of asset purchases. Most observed that the outlook for the labor market had shown progress since the program was started in September, but many of these participants indicated that continued progress, more confidence in the outlook, or diminished downside risks would be required before slowing the pace of purchases would become appropriate. A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome … Most participants emphasized that it was important for the Committee to be prepared to adjust the pace of its purchases up or down as needed to align the degree of policy accommodation with changes in the outlook for the labor market and inflation as well as the extent of progress toward the Committee's economic objectives…”

– FOMC Minutes (April 30 – May 1)

Fed officials are encouraged by the improvement in the job market, but see conditions as far from ideal. “Many,” suggesting a majority, want to see more progress before slowing the rate of asset purchases. “A number of participants,” less than a majority (although note that not all meeting participants get a vote on policy), would be willing to adjust the rate of asset purchases sooner rather than later. It’s been widely expected that the Fed would begin to taper the pace of asset purchases sometime in the second half of the year and then end the program in early 2014. The FOMC minutes are consistent with that view, but how the Fed reduces the pace of asset purchases may be tricky.

Recall that QE3 differs from QE1 and QE2, in that the earlier programs were of fixed length. QE3 is open ended. Importantly, it’s the total amount of securities purchased that matters, not the monthly pace. There was no significant increase in long-term interest rates when QE1 and QE2 ended. Similarly, there is unlikely to be much of an increase when QE3 ends. However, there is uncertainty about when QE3 will end. Anything that suggests an earlier end to the program, and therefore a lower amount of total purchases, would have some implications – but not a lot – for long-term interest rates. Similarly, a slowing in the rate of asset purchases would also reduce the expected total amount of asset purchases. The challenge for the Fed, assuming that it wants to reduce the rate of asset purchases, is to do it in such a way that the markets won’t assume that the end of the program is imminent. The minutes showed that FOMC members “agreed on the need to communicate clearly that the pace and ultimate size of its asset purchases would depend on the Committee's continued assessment of the outlook for the labor market and inflation in addition to its judgments regarding the efficacy and costs of additional purchases and the extent of progress toward its economic objectives.” To highlight its willingness to adjust the flow of purchases in light of incoming information, the FOMC included language in the policy statement that said it was “prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.”

In his JEC testimony, Bernanke took time to address fiscal policy and its impact on the recovery. The Fed chairman noted that federal fiscal policy, through discretionary action (the stimulus package) and through automatic stabilizers, was very accommodative early on in the recovery, but that was largely offset by spending cuts and tax increases by state and local governments. The strengthening economy has now improved the budgetary outlooks for state and local governments, leading them to reduce the pace of fiscal tightening. However, fiscal policy at the federal level “has become significantly more restrictive,” and currently “monetary policy does not have the capacity to offset an economic headwind of this magnitude.” Although near-term fiscal restraint has increased, “much less has been done to address the federal government’s longer-term fiscal imbalances.” In other words, lawmakers have made the current economic situation worse, while doing little to address the long-term problems. Is this a great country, or what?

The federal debt ceiling went back into effect on May 19. Did you notice? Recall that the debt ceiling was breached on December 31, but as part of the fiscal cliff deal, the debt ceiling was waved until February 15, and that was then extended to May 18 to give the new Congress more time to work on a budget deal. Oh, well. Through special measures, and as a consequence of an improved trend in tax receipts and a $60 billion payment from Fannie Mae coming on June 28, Treasury is expected to be able to fund the government through Labor Day. We tend to think of the debt ceiling as an issue between the two parties, but it has also sharply divided Republicans. That was evident last week amidfrictionbetween the Tea Party folks and other Republicans. It’s going to be a very long summer.

© Raymond James

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