Thursday, August 22, 2013

July FOMC minutes

The minutes of the July FOMC meeting indicate there was broad support amongst the committee members for the plan to initially taper their asset purchases program and end it altogether by the middle of next year.  However, there was no further elucidation of when that process might start or how quickly it would unfold.

As you know I’ve been less convinced than the average market expectation that the initial steps towards tapering will be taken in September.  The discussion in the minutes around the conditions for tapering didn’t change my mind.  I agree that US economic growth will likely be stronger in the second half than the first, but I don’t expect it to as strong as the current Fed forecasts indicate, in fact the Fed will most likely lower their 2013 growth forecasts in their next set of projections.  The key risk for me is that fiscal drag from lower government spending has further to play out.

I’ve also struggled with the continued expectation that recent low inflation readings would prove to be “transitory”.  There is no sign of that yet: core PCE inflation continues to trend lower.

Only the labour market appears close to meeting the conditionality.  The unemployment rate is now 7.4%, which is getting closer to the “vicinity of 7%” which is the condition for ending the program.  In another positive sign initial jobless claims continue to trend lower.   At the same time the Committee acknowledges the low participation rate and employment-to-population rate along with the high incidence of part-time work indicates that overall labour market conditions remain weak.

In summary the minutes were very balanced with appropriate acknowledgement of the risks to the expectation of stronger growth and inflation returning to 2%.  For me the labour market supports a “yes” to September tapering, inflation is a “no” and growth is a “maybe”.

That said, one way to end the market speculation and uncertainty is just to get on with it.  If that’s the case, I expect a very gradual tapering process to be outlined (e.g. a reduction of $10 billion per month) with continued conditionality around the performance of the labour market, growth and inflation.  I would also expect forward guidance to be amended to incorporate a lower unemployment rate (e.g. 6%) to reinforce it will be a long time before the Committee starts to raise interest rates.