The universal symbol for drama dates back to ancient Greece. It is the comedy-tragedy mask. If you are unclear about what that symbol looks like, picture two masks - one showing a happy face and the other showing a sad face. That is the comedy-tragedy mask. It can be found in your Playbill. It can be found on Mardi Gras necklaces. And it can be found at the upcoming FOMC meeting.
For nearly one hundred years, the Federal Reserve has created great theater for the capital markets with its monetary policy. Its plays always evoke a range of emotions, yet they rarely have a perfect ending.
The Fed's latest play has involved a number of cast members and a number of subplots. The main plot line, however, has been built around the idea that purchasing Treasury and agency mortgage-backed securities will produce a perfect ending for the labor market and the broader economy.
That plot line has yet to be fully developed -- even after the introduction of taking the fed funds rate to the zero bound and three subsequent acts of quantitative easing -- yet it sounds as if the Fed is ready to start bringing its play to a close.
To do so, the Fed will put on a happy face in public by calling attention to the improvement in the labor market. Behind closed doors, though, we think a sad face will be worn knowing it has been unable to write a perfect ending with its asset purchase program, where the costs have outweighed the benefits.
In his semi-annual testimony to Congress on the economy and monetary policy in July, Fed Chairman Bernanke clarified the role asset purchases are playing in monetary policy. Specifically, he said:
"We are using asset purchases and the resulting expansion of the Federal Reserve's balance sheet primarily to increase the near-term momentum of the economy, with the specific goal of achieving substantial improvement in the outlook for the labor market in a context of price stability. We have made some progress toward this goal, and, with inflation subdued, we intend to continue our purchases until a substantial improvement in the labor market outlook has been realized."
That view was shared several weeks after the Fed chairman created a stir following the June FOMC meeting when he said it would be appropriate to moderate the pace of purchases later this year if incoming data supported the Fed's projections for continued improvement in the economy. He said at the time, too, it was possible the program could come to an end by the middle of 2014 if substantial improvement in the labor market has been achieved.
With that, let's take a look at what the Fed's central tendency projections were at the time of the June meeting. These projections will be updated at the September 17-18 FOMC meeting.
Fed Economic Projections (central tendencies as of June 2013)
Change in Real GDP
2.3 to 2.6
3.0 to 3.5
2.9 to 3.6
2.3 to 2.5
7.2 to 7.3
6.5 to 6.8
5.8 to 6.2
5.2 to 6.0
0.8 to 1.2
1.4 to 2.0
1.6 to 2.0
Source: Federal Reserve
With the disappointing growth in the first half of the year, the Fed is likely to lower its central tendency projection for the change in real GDP for 2013. Even so, we suspect the Fed will fall back on the improvement in the unemployment rate and the uptick in PCE inflation as a basis for making a tapering announcement, albeit a light one (i.e. $10 bln), at the September meeting.
The unemployment rate dipped to 7.3% in August while PCE inflation for July increased 1.4% from the same period a year ago. The latter is an improvement from the year-over-year growth rate of just 0.9% seen in April; meanwhile, the unemployment rate compares favorably to the 8.1% rate seen in August 2012 and the 9.6% rate seen in August 2009, or shortly after the expansion of QE1 in March 2009.
The unemployment rate, of course, isn't as improved as it appears. On an absolute basis, it has come down in a big way to fit the Fed's narrative, but the statistical fact of the matter is that the notable improvement is a function of the drop in the labor force participation rate.
When the Great Recession began in 2007, the labor force participation rate stood at 66.0%. Today it is 63.2%, which is the lowest since August 1978. If the labor force participation rate was the same today as it was in December 2007, the unemployment rate would be 11.2%.
To be fair, baby boomers hitting their retirement years have played a part in the drop in the participation rate, yet that defense loses its resonance when taking into account that the employment-population ratio of 75.9% for prime-aged workers between 25 and 54 years old is below where it was in March 2009 (76.2%).
Furthermore, long-term unemployed workers (27 weeks or more) account for 37.9% of the unemployed. While that is down from 40.3% in September 2012 when QE3 was announced, it is still more than 50% higher than the 24.3% rate seen in March 2009.
The labor market is admittedly improved from where it was in March 2009 and there are more workers on nonfarm payrolls than there were in September 2012, but the pace of improvement has been too deliberate for anyone's liking.
Pinning a defense of a tapering announcement on the unemployment rate falling in-line with the Fed's projections, therefore, is little more than a smoke and mirrors defense. It is the happy side of things, but the sad reality is that the Fed, stacked with all of its economists, knows the improved unemployment rate is more a matter of statistical distortion than it is a matter of hiring fact.
Costs and Benefits
Ultimately, we think the message is hitting home for the Federal Reserve that the benefits of its asset purchase program are not outweighing its costs. That point was emphasized in a paper by Vasco Curdia and Andrea Ferrero, San Francisco Federal Reserve economists, who estimated that QE2 added just 0.13 percentage points to real GDP growth in late 2010 and only 0.03 percentage points to inflation.1
The average quarterly GDP growth rate of 2.1% since the second quarter of 2009 is another reminder that quantitative easing isn't having the intended effect of helping the economy achieve escape velocity. Restrictive fiscal policy has played a part in holding the economy back, but even before sequestration and the higher payroll tax, real GDP growth was still running at sub-optimal levels. As it stands today, the velocity of M2 money stock is at a five-decade low.
We would argue, too, that the realization the equity market is reliant on the so-called "Fed put," the recognition that the use of margin debt is near record levels, and burgeoning signs of speculation in certain housing markets are starting to lend credence to Kansas City Federal Reserve President George's concerns that the continued high level of monetary accommodation has increased the risks of future economic and financial imbalances.
From our vantage point, the cost-benefit consideration will be the biggest driver behind a decision to taper in September, but we don't think the FOMC will be explicit in stating as much, opting instead to emphasize the improvement in the labor market.
Were it to emphasize the cost-benefit factor alone, the Fed would essentially be admitting its policy approach has been a failure. That would sap its credibility and the Fed won't risk doing that.
Lines of Communication
The communication stakes will be high for the FOMC and Fed Chairman Bernanke. The Fed will likely conclude that it is time to take a small step down in its asset purchases while trying to convince the market that:
- it is not on a preset course for tapering (i.e. it could raise its purchases again if the data dictated doing so)
- a tapering is not a tightening of policy (clearly not how the Treasury market has thought of things) and
- an actual hike in the fed funds rate is still a long way off
The idea of a "light tapering" has been talked about enough now that it won't be a surprise to the market. What would be a surprise is:
- No tapering announcement (likely reaction: positive)
- The FOMC decides to cut its purchases by more than $15 bln (likely reaction: negative)
- The FOMC announces a reduction in its purchases of agency MBS (likely reaction: negative on concerns it will lead to a slowdown in housing demand)
- The FOMC announces a light tapering, but increases its forward guidance by lowering the threshold for the unemployment rate as a marker for an increase in the federal funds rate (likely reaction: positive)
What It All Means
While we have said in the past that we don't think the economic situation is strong enough to warrant a tapering announcement at the September FOMC meeting, our assumption, based on the chatter of Fed officials, the reduced budget deficit, and the drop in the unemployment rate, is that the FOMC will decide to reduce its asset purchases by $10 bln, cutting only its purchases of Treasury securities.
If the Fed decides at the September meeting to stay the current policy course, we will of course be mired in the same will-they-or-won't-they debate leading up to the October 29-30 FOMC meeting. That would be both a comedic and tragic element at the same time.
It is a possibility given the unsettled nature of the Syrian situation, the budget agreement, and the debt ceiling debate, not to mention the uneven economic data and labor market conditions that still leave a lot to be desired.
In ancient Greece, the comedy-tragedy mask was a prop for actors to convey a character's feelings. It was also seen as representing the two sides of Dionysus, the Greek god of wine, and the dichotomous influence of wine consumption that includes drunken revelry and sorrow.
There has been no mistaking the influence the Fed's asset purchase program has had on the stock market. At the same time, we have started to see in the Treasury market that the idea of the Fed pulling back on its asset purchases is producing feelings of sorrow.
It will take a command performance by Fed Chairman Bernanke at his upcoming press conference to manage the market's expectations and to preserve the Fed's credibility. He gave a disappointing performance at the last FOMC press conference in June.
He'll have to have his game face on or, rather, his comedy-tragedy mask to let the market clearly know what the Fed is thinking. A plot line, and an imperfect ending, hang in the balance for global markets.
(1) Curdia, Vasco, and Andrea Ferrero. 2013. "How Stimulatory Are Large-Scale Asset Purchases?" FRBSF Economic Letter. 2013-22.