It seems clear that most Fed policymakers have not decided whether to begin reducing the pace of asset purchases. Officials will review a wide range of data and anecdotal information this week. It’s generally (but not universally) expected that this will lead the Federal Open Market Committee to begin tapering, but modestly, while signaling a wait-and-see attitude on further action. The Fed should continue to stress that short-term interest rates will remain low for some time. The economy is still far from being fully recovered, but we’re well on our way. The only major threat is what’s going on in Washington.
The Fed’s asset purchase program (QE3) was meant to impart some degree of momentum to the overall economy. Over the last year, the labor market has improved. Job destruction has remained low and has even drifted down a bit more over the last month. New hiring is gradually picking up.
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Much has been noted recently regarding the fifth anniversary of the failure of Lehman Brothers, which kicked off the worst part of the financial crisis. However, one aspect has been missing from many of these accounts. Commercial banks tightened credit on small businesses substantially in the fall of 2008. We normally look to small firms to account for most of the job creation during an economic expansion. With bank credit tight, these firms were unlikely to expand. However, even those firms with good credit did not necessarily want to take on additional financial obligations – at least not until they saw a sustained increase in demand for the goods and services they produce. In the aggregate, you need job gains to fuel spending and you need increased spending to boost jobs. Typically, jobs and spending will recover gradually over time.
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If we were at full employment, the pace of growth over the last few years would be fine. However, we’re not at full employment. Real GDP is at a pace that is roughly 5.6% below its potential. That’s a significant shortfall. Moreover, a continued low trend would further reduce potential GDP.
This line of reasoning would suggest that the Fed should keep the pedal to the metal. The current low trend in inflation allows the Fed some leeway in maintaining the current pace of asset purchases. However, the Fed’s asset purchase program cannot go on indefinitely. The Fed will still be adding policy accommodation as it slows the rate of asset purchases – and if the economy were to stumble, the pace could be increased. Moreover, the Fed will continue to provide support for the recovery through low short-term interest rates.
The Fed chairman has been widely criticized for agitating the financial markets with his talk of tapering. Oddly, Bernanke has been extremely clear in his communications. Yet, the markets often don’t seem to understand what he says. At the same time, investors typically worry about things they shouldn’t worry about (Fed tapering), and don’t worry about the things they should worry about (a manufactured crisis over the budget and debt ceiling). More about this next week…
© Raymond James
