FOMC Week

by: Tim Duy

You can almost smell the excitement in the air - this week we have a two-day FOMC meeting to look forward to, culminating on September 19 with not only the policy statement, but also a press conference by Federal Reserve Chairman Ben Bernanke. Does it really get any better than this? It does, because odds are that the FOMC moves forward with its plan to end asset purchases with a small, very small, reduction in the pace of asset purchases of $10-15 billion. I anticipate the cut to focus on Treasuries, as the Fed will not want to risk further aggravating the mortgage market. I also anticipate a fairly dovish statement - and subsequent press conference - to make clear that an end to asset purchases does not necessarily imply an earlier beginning to rate hikes. In short, the Fed will likely be taking its first step toward normalizing policy this week.

At this point, the tapering question has been debated to death. On one side is the question of whether or not the evolution of the economy since Bernanke's June press conference is "broadly consistent" with the FOMC's forecasts. The drop in the unemployment rate and the upward revision in 2Q GDP both point in that direction, as does the recent inflation uptick:

3MCOREPCE090213

To be sure, the counterargument is that even if GDP is growing faster than originally thought, it is by no means growing at a gang-buster pace, or anything likely to close the output gap in any reasonable amount of time:

FEDGDP091513(Potential GDP is the CBO estimate adjusted upward by percentage difference between the pre- and post- July 2013 GDP revisions for 2011. Use with caution; expect additional CBO updates.)

And, although unemployment is falling, it still remains well above even short-run estimates of NAIRU:

FEDUN091513

Moreover, it remains too early to say inflation is definitely moving toward 2%:

PCE091513

and the Evan's rule gives us some upside leeway on that number anyway.

All true, but it is likely that the FOMC will interpret these arguments as reasons to begin with a small reduction in asset purchases rather than delay the taper all together. Primarily, I believe the FOMC is increasingly biased against asset purchases in favor of forward guidance. They view asset purchases as most effective during periods of financial crisis, and less so in a more normal environment. They view their goal of achieving "stronger and sustainable" growth in labor markets as largely met given that private sector job growth did not collapse in the wake of the fiscal contraction.

Moreover, I believe they are concerned about the possibility of financial market dislocations from additional asset purchases. The rapid jump in interest rates after Bernanke's press conference will be seen internally as support for those concerns. There is also the additional concern that Treasury purchases are sucking up the supply of much needed safe assets / collateral from the private sector (see Matthew Klein and Cardiff Carcia). I don't think you would ever get the Fed to admit the latter publicly, as it is essentially saying that monetary policy dramatically loses its effectiveness at the zero bound in the absence of the cooperation of the fiscal authorities who issue those safe assets. That said, Bernanke has implicitly said as much when he has admonished Congress for excessive fiscal austerity.

On top of all of this, I suspect the FOMC may be moving toward an epiphany on the labor force participation rate, specifically that much of the decline is structural. See Gavyn Davies here on his changing thoughts, and review the debate in this speech by San Francisco Federal Reserve President John Williams. Honestly, I am not surprised - some worried years ago that in a protracted period of weak growth, cyclical unemployment could become structural. And the Great Recession probably accelerated the demographic changes in the labor market that were already occurring, and may have permanently damaged the outlook for younger workers as well. All doom and gloom, to be sure. The further the Fed moves in this direction, the more they will think that estimates of potential GDP are still too high and that their unemployment rate forecasts are too pessimistic.

The latter creates an interesting problem for the FOMC regarding its likely dovish statement emphasizing forward guidance. That forward guidance is based on the unemployment rate, and it is difficult to see how the forecast for the unemployment rate becomes more optimistic while at the same time holding rate expectations at least constant. A solution would be to lower the unemployment threshold to 6% from the current 6.5%, although this seems like a pretty big step-- and as such, I am hesitant to embrace it as a primary scenario for this meeting. Instead, expect the statement and press conference to more strongly reiterate the uncertainty about the labor force participation rate, note that even if inflation is now moving in the right direction it still remains below 2%, and highlight the 50bp room above the 2% inflation target that already exists within the current forward guidance.

That said, you see the obvious risk here - that over the course of the next six months, more evidence emerges to support the case that the unemployment rate remains the single best indicator of labor market tightness and that the decline in the labor force participation rate is largely structural. In such a world, the Fed could easily find itself raising interest rates sooner than their own forward guidance would suggest.

Other possible outcomes include the Fed does exactly nothing, or that they move forward than a bigger than expected cut to asset purchases. The argument for the former can be found above. The latter could be justified if the Fed has already largely embraced the structural story for the decline in the labor force participation rate. Moreover, there is an interesting issue regarding date- or data-based policy. In his press conference, Bernanke said they expected the unemployment rate to hit 7% by the middle of next year, and that would be an appropriate time to wrap up asset purchases. But it is reasonable to believe that the unemployment rate hits 7% by November (employment report issued in December) of this year - so if the Fed maintains a gradual pace of asset purchases, was Bernanke's guidance really data-based or was it date-based? Indeed, given the 7% trigger than Bernanke put up in June, how could they not begin asset purchases now? It leads one to wonder if the Fed understands enough about its own communications to effectively implement a forward guidance strategy.

Bottom Line: This week most likely marks the beginning of the end for asset purchases.