Don't worry. If things go bad - economically speaking - the Federal Reserve will simply increase its asset purchases again to save the day (and the stock market).
Sounds like a comforting thought, doesn't it? After all, who can forget how well the stock market did with the step up to QE1, the further step up to QE2, and the high step to QE3? What harm can there be in climbing another QE step?
Frankly, we don't want to find out, but if it comes to that, it isn't likely to be the same cathartic experience for the stock market that some investors think it will be. Things are different now that the tapering process has started. People, forecasts, and attitudes have changed.
Sure, the Fed could go back to buying $85 bln, or more, per month of long-term Treasury securities and agency mortgage-backed securities, but the fact of the matter is that the Fed can't really go home again.
Don't Go There
From our perspective, the Fed passed the point of no return when it made the announcement at the December FOMC meeting that it will be curtailing its asset purchases by $10 bln per month on account of the "...cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions."
With the aforementioned announcement, the Fed also made it clear that forward guidance is its preferred policy tool now for holding down interest rates. Our cynical view is that the shift had more to do with the Fed's growing concerns about the size of its balance sheet.
Granted the outlook for labor market conditions has improved, but it is also plain for economists at the Fed to see that the drop in the labor force participation rate has had a lot to do with the progress toward maximum employment. Moreover, while the December tapering decision was strikingly devoid of any consideration for inflation trends, it was also plain to see at the time that PCE inflation (+0.9% yr/yr) was still running well below the Fed's longer-run objective.
The Fed nonetheless chose a new path and now it must continue to follow it. The option of the Fed increasing its asset purchases is still there, yet it's not the viable option it used to be for several reasons:
- Philadelphia Fed President Plosser and Dallas Fed President Fisher are voting FOMC members in 2014. Both have been very vocal about their concerns over the expansion of the Fed's balance sheet. Their concerns pre-date their voting status, so it becomes a much harder sell now to convey credibly that there is a collegial view that increasing the Fed's asset purchases is the right way to go.
- There has been a concerted effort to emphasize forward guidance as the primary policy tool. Backtracking now would undermine the Fed's credibility.
- Increasing asset purchases now won't be a confidence builder because the real economic benefits of past quantitative easing have been deemed insufficient relative to the size of the Fed's balance sheet.
- Increasing asset purchases would be seen as increasing the risks of future imbalances given the surge in stock prices that coincided with prior QE programs.
- The political backlash would be significant, placing the Fed's independence at risk.
- The Fed's economic forecasting ability, already in question, would be discredited, heightening concerns about the Fed's credibility that could upset the Treasury market.
It's In The Messaging
The Fed has done a convincing job so far of selling the market on the idea that tapering is not tightening. In the process, it has boosted the market's confidence in the economic outlook.
That confidence has translated into robust gains for many of the cyclical sectors over the last three months in particular when Fed officials have made a concerted effort to change their messaging.
3Mo. % Change
Source: FactSet (data as of 1/16/14)
A decision in the future to increase asset purchases would only be precipitated by a dramatic weakening in labor market conditions and/or inflation rates. Neither is in the Fed's forecast nor are they in the forecasts of most economists.
Fed Economic Projections (central tendencies of December 2013)
Change in Real GDP
2.2 to 2.3
2.8 to 3.2
3.0 to 3.4
2.5 to 3.2
2.2 to 2.4
7.0 to 7.1
6.3 to 6.6
5.8 to 6.1
5.3 to 5.8
5.2 to 5.8
0.9 to 1.0
1.4 to 1.6
1.5 to 2.0
1.7 to 2.0
Core PCE Inflation
1.1 to 1.2
1.4 to 1.6
1.6 to 2.0
1.8 to 2.0
If the Fed is compelled to go back to the QE well, though, the cyclical sectors would be at heightened risk of underperforming as optimistic expectations get wrung out of stock prices. That would likely happen prior to the Fed actually increasing its asset purchases since investors would be privy to the disappointing economic data beforehand.
What It All Means
By and large, the economic data have remained supportive of the Fed's tapering announcement in December. The December employment report was an outlier in that respect, but a number of Fed officials have already downplayed the face value of that report.
There is no basis at this time for thinking that the Fed will increase its asset purchases in the near future. It's possible that the Fed could defer a tapering decision, but it seems more likely (and more inclined) to continue down the tapering path along with its friend forward guidance.
There might be a day when the Fed increases its asset purchases. It's not out of the realm of possibility. That would not be a good day for obvious economic reasons and we doubt it would be the saving grace the stock market came to rely on the past five years.
Investor expectations are higher now for the economy to stand on its own. The Fed has contributed to those expectations. Alas, it won't be the same as before going back to the Fed's familiar place of increasing its asset purchases.
The Fed has flown the coop, so to speak. It can still return home, but it can never really go home again because things have changed.