On Tapering, All Signs Point to “Maybe”

Investors looking to the July 30-31 Fed policy meeting minutes for clear clues on future moves were left disappointed. Nearly all senior Fed officials expect that a reduction in the pace of asset sales is likely to be warranted by the end of the year. However, they appear evenly divided on whether that will be sooner (September) or later (December). The economic data remained mixed, suggesting that the decision will be a close call.

Recall that the asset purchase program (QE3) has a qualitative threshold: “substantial improvement” in the labor market. The FOMC minutes noted that “the unemployment rate has declined considerably” since last fall (when QE3 began) and “recent gains in payroll employment had been solid.” However, “other measures of labor utilization – including the labor force participation rate and the numbers of discouraged workers and those working part time for economic reasons – suggested more modest improvement, and other indicators of labor demand, such as rates of hiring and quits, remained low.” Picture Janet Yellen, with a slow wave of her hand, “this isn’t the job market improvement you’re looking for.”

Recent comments by senior Fed officials have been mixed, and the split was also apparent in the FOMC minutes: “a few members emphasized the importance of being patient and evaluating additional information on the economy before deciding on any changes to the pace of asset purchases. At the same time, a few others pointed to the contingent plan that had been articulated on behalf of the Committee the previous month, and suggested that it might soon be time to slow somewhat the pace of purchases as outlined in that plan.”

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With no definitive direction from the Fed, investors looked to the economic data for indications of whether it would be appropriate to delay the tapering of asset purchases. Existing home sales continued to improve in July, but new home sales figures tanked. The new home sales data are unreliable. For those of you who stayed awake in you statistics class, the reported 13.4% decline in new home sales for July was not statistically different from zero. Homebuilder sentiment continued to improve in August, suggesting that any softness in sales is more due to short-term supply constraints.

The Fed was initially puzzled by the market response to tapering talk. Minutes show that some Fed officials thought than the rise in long-term interest rates may have reflected the mistaken belief that a tapering in the pace of asset purchases implied an earlier increase in the federal funds target rate. However, the emphasis on the forward guidance (on short-term interest rates) likely countered that. Fed officials put forth a number of theories on why long-term interest rates have risen: a perception of a complacency regarding inflation; an improved outlook for economic growth; a realignment of market expectations of Fed policy. Some officials “felt that overall financial market conditions had tightened significantly and expressed concern that the higher level of longer-term interest rates could be a significant factor holding back spending and economic growth.” However, “several others judged that the rise in rates was likely to exert relatively little restraint, or that the increase in equity prices and easing in bank lending standards would largely offset the effects of the rise in longer-term interest rates.” Some officials “stated that financial developments during the intermeeting period might have helped put the financial system on a more sustainable footing.”

Many financial market participants blamed the Fed for fueling a bubble in emerging market economies – a bubble which now appears to be coming unwound. However, global capital flows are more complicated than that. Amid the recession and expected gradual recovery, global investors were not enthusiastic about putting money into the U.S. or Europe. The emerging economies had a compelling long-term story. These countries would see, over time, the development of a middle class, improved standards of living, and substantial growth. That long-term story is still valid, but in the short run, it’s looking a little iffy. Signs of improvement in the U.S. and stabilization in Europe, combined with relatively subpar results in emerging economies, have turned capital flows around. And as one usually sees, such flows tend to be self-reinforcing.

A key paper presented at the KC-Fed’s annual monetary policy symposium in Jackson Hole concluded that it was “imperative” that central banks outline a framework for the use of large-scale asset purchases: “ without such a framework, investors do not know the conditions under which asset purchases will occur or will be unwound, which undercut the efficacy of policy targeted at long-term asset values.” Amen to that.

© Raymond James


© Raymond James

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