Taper Time?

There are many arguments for and against an initial reduction in the Fed’s monthly rate of asset purchases, but the balance has shifted toward a December taper. It appears to be a very close call, but even if the Fed decides to delay again, we all know (or should know) that QE3 is going to wind down in 2014.

Arguments for a taper:

1) We’ve seen substantial improvement in the labor market since September 2012, when QE3 began.

2) Other recent figures suggest that the economy may be gathering some momentum.

3) Federal fiscal policy was a major headwind for the economy in 2013. Fiscal restraint at the federal level will be much more modest in 2014 and should be more than offset by increases in state and local government.

4) The mini budget deal means no government shutdown in January, eliminating one hurdle for the taper.

5) Tapering has to begin at some point. The asset purchase program was not meant to last forever. The Fed will continue to add policy accommodation as it slows the rate of asset purchases and its forward guidance on the overnight lending rate will continue to provide support to the economic recovery into 2015.

Arguments against a taper:

1) While the job market has improved, it’s far from fully recovered. Long-term unemployment remains elevated.

2) While other economic figures suggest improvement, it’s unclear whether that will last. The government shutdown may have distorted some of the recent data.

3) Higher home prices and rising mortgage rates have reduced affordability, threatening the housing recovery.

4) Inflation is trending far below the Fed’s 2% target. A continued low trend in inflation could create a number of problems for the economy.

5) The financial markets are not entirely prepared for a taper, which could push long-term interest rates higher.

The federal budget deficit fell to around 4% of GDP in FY13 and appears likely to reach 3% of GDP in FY14 and near 2% of GDP in FY15. Does the rapidly declining federal budget deficit mean that, all else equal, the Fed should be buying fewer Treasuries? Yes, but remember that the deficit had been expected to fall anyway. The increase in payroll taxes and sequester cuts had some impact on the budget, but they also slowed the recovery, limiting the improvement in tax revenues. More importantly, what matters for the Fed is the total amount of assets purchased as a fraction of overall Treasury debt. Smaller deficits haven’t had much of an impact on total Treasury debt and therefore on the ratio of Fed purchases.

On balance, recent economic data have made the Fed’s taper hawks more hawkish, and the taper doves less dovish.

St. Louis Fed President Bullard (votes on the FOMC in 2013) noted that “recent results suggest that the coming months will show continued labor market improvement.” It’s possible that labor market improvement will slow down, Bullard said, “and the FOMC needs to assess whether progress made in the labor markets will continue.” Bullard has been the most vocal regarding concerns about low inflation. He formally dissented against even mentioning “tapering” in the policy statement in June. More recently, Bullard said that low inflation allows the Fed to maintain an aggressive policy stance. However, “a small taper might recognize labor market improvement while still providing the FOMC the opportunity to carefully monitor inflation during the first half of 2014.”

Minneapolis Fed President Kocherlakota (votes on the FOMC in 2014) has suggested that policymakers should lower the 6.5% unemployment rate threshold in its forward guidance. Doing so, he argued, would provide better stimulus for the economy than asset purchases. However, other Fed officials are not on board for such a move. Fed research shows that forward guidance is a lot more effective than asset purchases in supporting economic growth. However, financial market participants generally remain confused by the thresholds, which are guideposts, not goals. Bernanke has repeatedly indicated that the federal funds target rate will remain exceptionally low even after the unemployment rate falls below 6.5%. However, the markets are likely to price in an earlier tightening as we near that threshold (and at the rate things are going, we could easily see 6.5% unemployment by the middle of 2014).

When the Fed began to talk about tapering in the spring, the markets responded by pricing in an earlier increase in the overnight lending rate. This was an unwelcome development for the Fed. Tapering is not tightening. Tapering does not mean that the Fed will begin raising short-term rates any sooner.

Fed research suggests that purchases of mortgage-backed securities are more effective than purchases of long-term Treasuries. The Fed remains concerned about the recovery in the housing sector. Hence, an initial reduction in the rate of asset purchases should be concentrated in Treasuries.

Monetary policy under Janet Yellen is initially not going to be any different than under Bernanke. Yellen will face some major challenges. The Fed has to determine the pace of tapering, and while policy will still remain data-dependent, the Fed has to weigh the data, which will be mixed. A bigger concern is how the Fed will communicate its intentions. Bernanke was perfectly clear, but the markets don’t often hear very well.

© Raymond James


© Raymond James

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