The Federal Reserve’s open window for ending quantitative easing may not last longer than this FOMC meeting or the next. Any number of economic, political or bureaucratic developments could slam the window shut. If the Fed is to act on a change of monetary policy it may have no choice but to move now, despite the equivocal nature of the economic evidence.
Herewith the logic for tapering:
1. The economy is better. Maybe the improvement is minimal but it is enough for the Fed’s purpose. The risk of recession is discounted. Although job creation has been declining slowly over the past twelve months, from 208,000 and 207,000 in the last quarter of 2012 and the first quarter of this year, to 182,000 in the second quarter and to 137,000 in the first two months of the third quarter, it remains passable. That would change quickly with a poor report for September and the revisions in August are worrisome.
GDP jumped to 2.5% annualized in the second quarter from 1.1% in the first. Neither payrolls nor GDP are likely to match first half performance in the second. The economic history of the past three years with better statistics and activity in the first half of the year is a warning. Between an economic past that is acceptable and a future that is at best uncertain and could be derailed by a run of bad statistics or any number of events in a dangerous world this may be the best economic window that the Fed will see.
2. Quantitative easing was intended to be a temporary expedient. In the Fed’s own analysis it has not been very effective at fostering economic growth. Its intent was largely psychological, to create a ‘wealth effect’ through higher equity prices that would circle back to the real economy in higher consumer spending and perhaps investment. The Dow is up 20% this year on 1.8% economic growth in the first half. If the ‘wealth effect’ were real the economy would be booming. Whatever the positive impact of easing it has probably run its course.
3. Quantitative easing is producing distortions in some important markets. Equities have become highly dependent on the perception of unlimited Fed support as have bonds. When Ben Bernanke seemed to confirm on June 19th that quantitative easing would diminish by $20 billion at the September meeting, the Dow dropped 764 points, 4.9% to June 24th.
From May 2012 to April 2013 the yield on the 10-year generic Treasury averaged 1.74%. The 20 year average is 4.6%. The 10-year Treasury yield has been rising and bond prices falling since early May. Mr. Bernanke’s June 19th assertion sent that into overdrive. While it makes economic sense to make the adjustment to more normal rates as gentle as possible, hence the Fed’s jawboning on rates in July, the longer the wait to begin the more difficult the weaning of the markets will be.
The Case/Shiller 20 city year on year home price index was 12.7% higher in June, the fourth month in a row of double digit gains. Prices are nowhere near as frothy as at height of the housing bubble. From 2003 to 2005 prices rose an average of 14.1% each year, a 42% gain in three years, with many individual markets far outstripping the nationwide performance.
Unemployment averaged 5.5% in those years with an employment rate (labor force participation rate) of 66.1%. Unemployment is currently 7.4% with the participation rate at a 35 year low of 63.2%. Household income is lower than at the start of the recession.
Even with the fall in home prices since the collapse of the housing bubble, prices are still above the long term Federal Housing Finance Agency trend. It is hard not to assume that a good portion of the recent trend in prices is due to the market support from excessively low interest rates. Housing starts and building permits have dropped 10% and 5% from their levels earlier in the year.
The farther the market rises the greater potential fall and economic damage when rates normalize.
4. Inflation is quiescent; the vast amounts of liquidity pumped into the financial system have not stirred inflation or inflationary expectations. The core PCE rate y/y was 1.2% in July. The CPI core rate y/y was 1.7% in July and 1.8% in August. It has turned up from 1.6% in June, ending 13 months of disinflation that began in June of last year. Though the PCE rate is forecast to remain at 1.2% when it is released on September 27th, perhaps Chairman Bernanke can take some deflation comfort from the reversal in CPI.
5. The Fed can always pull back from any taper. Chairman Bernanke has said more than once that future quantitative easing policy could go either way depending on the state of the economy. After the policies of the past five years markets would expect a return to easing should the economy falter or be threatened by economic or political developments elsewhere in the world. The biggest risk from a change in quantitative easing is in managing the reactions of the credit, equity and currency markets.
6. The Fed has already decided to begin the end of quantitative easing. That is the only possible explanation for Mr. Bernanke’s policy statements on May 22nd, June 19th and July 10th. The economic window for this change is open, barely.
On the FOMC the chairman has a consensus for the end of quantitative easing. But this bureaucratic permission could soon vanish. The current dispensation could and probably will change under a new chairman. Mr. Bernanke’s term ends this January 31st, four and a half months from now. Soon, likely very soon, will begin public comment and pressure to leave the quantitative easing decision to the next chairman who, after all, will have to oversee and implement this policy for the next four years.
There has been little or no political pressure for the Fed to keep open the money spigot. But that could change as well. Congressional elections are in a little over a year, a rounding error in most economic trends. The pressure on the Fed and especially the new chairman to provide as much support as possible to the economy going into the election may be hard for a new chairman to resist. If the change in policy is not effected before these pressures surface and particularly before a new chairman takes over, the consensus for termination could dissipate. Its revival could be a long time coming.
Ben Bernanke’s chairmanship of the Fed will always be associated with quantitative easing, an extraordinary policy for extraordinary times.
After eight tumultuous years the Chairman knows the economic and political possibilities better than anyone else. If he thinks it is time to end this experiment in monetary policy, he will be very hard placed not to begin before his term is over. In practical terms that means a policy change at this FOMC or at the very latest the next.
If the Fed does not end quantitative easing soon, it may be too late.
Chief Market Strategist
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