Thursday, May 23, 2013

The Fed will not end QE prematurely

A thorough read of the minutes of the April 30 / May1st meeting of the Federal Open Market Committee (FOMC) shows a Committee not in any mood to risk an early or premature end to the asset purchase program.  Markets have focussed on Ben Bernanke’s comments during his Congressional testimony that suggested the FOMC could potentially reduce the quantum of asset purchases “in the next few meetings”.  The important qualification was that this would only happen if the outlook for the economy continues to improve along with the level of confidence in the sustainability of that improvement.

The assessment of the current state of, and outlook for, the economy in the Minutes bore no surprises.  The meeting participants recognised the costs of fiscal drag in constraining aggregate demand, the improvement in the housing market (though off a low base) and that progress was being made in the labour market.  However, the Committee also noted that the recent decline in the unemployment rate is overestimating the reduction in slack in the labour market given the decline in the participation rate.

I have made the point before that it is unlikely a reduction in the unemployment rate that has been in large part due to people opting out of the labour market meets the FOMCs conditions for a substantial improvement in labour market conditions.  While there are structural reasons why the participation rate should be trending lower, I think at least some part of the recent decline is cyclical.  If that were to be reversed continued modest jobs growth could be accompanied by a stabilisation or even increase in the unemployment rate.  Time will tell.  The Committee also noted the recent soft inflation readings.  Core Personal Consumption Expenditure (PCE) was 1.1% in the year to March.

Much has been made in the media that “one participant” preferred to begin decreasing the rate of asset purchases immediately, but has missed the point that “another participant” wanted to add more stimulus at that meeting.  The important point is: “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.”  While that was in response to the weaker data at that point, especially the initial read of March payrolls data, it also seems to me the Committee didn’t want markets to get too far ahead of themselves in anticipating an end to the asset purchase program.

My read of the minutes, Bernanke’s testimony to Congress and other recent speeches from FOMC members (Bullard, Dudley) is that the Committee is not going to be in any rush to do anything other than continuing to ease.  In his testimony Bernanke made the important point that a premature tightening of monetary policy could lead interest rates to rise temporarily but could also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further.

Given our outlook for the economy we believe the next move in US monetary policy is a tapering in the pace of asset purchases.  However, they will need to be conscious of not starting to taper too early.  As soon as they start the process markets will anticipate the eventual cessation of the program and eventual tightening, even though the Fed will still be easing at that point.  We continue to expect the earliest we will see a reduction in the pace of asset purchase will be the end of this year, although recent inflation data is probably more indicative of a 2014 start to that process.  The good news is that when the tapering begins, it will be because the FOMC sees a fundamental improvement in the outlook for the US economy.