More Heat Than Light

Following their surprising decision to maintain the current pace of quantitative easing (QE), Fed officials provided more detailed reasoning last week in public remarks and interviews with media outlets. Unfortunately, the latest comments added more heat than light to the QE debate in our view. Much like Chairman Bernanke’s post-meeting press conference, officials expressed contradictory views on several major policy questions. They also provided relatively little information about the framework that will guide the QE tapering decision in the future. At this point we continue to expect the initial tapering announcement to come in December, but our confidence remains low.

In explaining the decision to delay tapering, several officials expressed concern about lackluster growth, implying that the QE wind down should only begin in an environment of more robust expansion. New York Fed President Dudley was the most direct, saying that tapering required “information about the economy’s forward momentum that makes [him] confident that the labor market improvement will continue in the future.” He then argued that the data had not yet passed this test—specifically citing the roughly 2% annualized rate at which gross domestic product (GDP) has increased since the recovery began.

Adding a growth-based trigger for the beginning of tapering potentially sets the bar very high. U.S. growth has been modest but mostly consistent over the last four years, making the odds of a sudden breakout to 3% or higher seemingly low. However, other comments this week hinted that whatever growth metric the Fed is targeting was not very far out of reach. For instance, at least three officials described the no tapering decision as a “close call.” In addition, Chicago Fed President Evans stated simply that the economic outlook “strikes [him] as compatible with reducing the flow of purchase rate.” Thus, growth momentum factored into the decision at the last FOMC meeting, but we cannot be sure what will qualify as sufficiently firm growth in the future.

One issue dividing policymakers is the long-running debate around the labor force participation rate (LFPR). Both Presidents Dudley and Kocherlakota said that the falling LFPR meant that the decline in the unemployment rate over the last year overstated the improvement in the labor market, and that this was another reason to delay the start of tapering. Other officials have expressed conflicting opinions, including President Williams in a speech before the last meeting and Chairman Bernanke at the post-meeting press confidence. In any case, the continued debate raises the question of why the committee introduced unemployment rate-based policy rules if it was divided over this central issue.

There was one question on which Fed officials expressed broad-based agreement last week: tapering will probably not begin in October. President Lockhart said that the he doesn’t think “the fog will clear dramatically” between now and then—a sentiment shared by other speakers. More critically, President Lacker said it would be hard for the committee to act in October “without losing face.”

Looking ahead, we see two broad ways in which Fed policy could play out. First, growth could accelerate, conveniently allowing the FOMC to begin tapering later this year while maintaining a mostly consistent message to markets. Second, growth could remain around 2% while the unemployment rate and the LFPR continue to decline—i.e. the environment we have observed for the last four years. Under this latter scenario, Fed officials would be forced to continue QE much longer than previously planned (presumably with rising pessimism about the program’s efficacy), or taper anyway and backtrack again on their guidance to markets.

Our best guess is that the first scenario is more likely—that growth will be firm enough over the next few months to allow tapering to begin in December. But we would not rule out the alternative scenario and could conceive of either a significantly longer bond buying program or another messy communication breakdown.


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