Sunday 15 September 2013

MacroWatcher: Fed Tapering and Weekly Notes

The Federal Reserve’s quantitative easing program, announced in November 2008, has coincided with many positive developments. Equity markets have rallied strongly, the housing market has begun to recover, unemployment figures are improving and banks have recapitalized. This week the Fed holds a two-day meeting and may subsequently declare a tapering of QE; something eagerly anticipated by markets.

Two-thirds of economist respondents to a Wall Street Journal poll expect some form of tapering to be announced Wednesday, but that number is surprisingly small. Markets appear to have priced in a taper, with bond yields rising sharply since Fed Chairman Ben Bernanke first hinted at the possibility back in May. The recent improvement in the unemployment rate, falling to 7.3% from 8.1% last year, has further bolstered expectations of a reduction in the Fed’s asset purchases. If the Fed were to postpone a tapering decision this week there could be a swift reaction. Market volatility would increase and the Fed’s ability to communicate effectively to markets will be cast into doubt.

The central bank will be keen to avoid a jolt in markets and will likely reveal some form of QE reduction. Currently, the program involves $85 billion of monthly bond-buying and this number will likely be decreased to $70 billion, probably involving a reduction in both mortgage and treasury purchases.

Economic fundamentals may prevent the Fed from tapering by a larger number. While the unemployment rate has declined, labor force participation has also fallen markedly, dampening the significance of a lower jobless figure. Moreover, monthly nonfarm payrolls were disappointing in July and August. Therefore, a relatively small $15 billion tapering will not significantly upset the impact of QE while also allowing the Fed time to analyze future economic data before committing to further reductions. This number should be enough to satisfy markets that already have tapering priced-in, while also setting in motion the Fed’s efforts to normalize monetary policy.

To assuage any economic concerns, Bernanke will likely emphasize that the reduction in QE is not indicative of future tightening by saying that monetary policy will remain accommodative. The Fed has said that a 6.5% unemployment rate and 2.5% inflation are targets for monetary tightening, but given the decline in labor force participation it may be communicated that a realization of these figures will not result in immediate changes in policy.

Of course, the Fed could announce a larger or smaller taper than the widely expected $15 billion. A larger reduction seems unlikely given the mixed US data of late, while a smaller number could see some volatility in bond markets. Markets will also be watching the Fed’s revisions of its GDP, unemployment and inflation projections from 2013 to 2015 and also its new forecasts for 2016. An interesting dichotomy will emerge if the Fed announces tapering while also revising GDP lower. However, such an outcome is unlikely given that the Fed has overestimated GDP in recent forecasts.

Dangers of Single Data Point

The validity of the US initial weekly jobless claims was cast into doubt last week. On Thursday the Bureau of Labor Statistics reported that the previous week’s claims were 292,000; the lowest level since April 2006 and 38,000 below economists’ consensus expectations. The number was surprising, but was devoid of any credibility when the Bureau revealed that most of the decline was due to two states retooling their computer networks, resulting in faulty reporting. The incident highlights the dangers of allowing one stream of data to influence an economic perspective.

Japan’s Tax

Good news came from Japan last week as prime minister Shenzo Abe will risk his domestic political popularity to implement an increase in sales tax next April. Although not yet officially announced, the decision to raise value-added consumption tax from 5% to 8% will help address the nation’s growing public debt burden [expected to be 230% of GDP by 2014].

There were some concerns that Abe may renege on the locally unpopular tax. But such a development would cast doubt on whether the government was committed to addressing its finances while simultaneously increasing the likelihood of future ratings downgrades and Japanese sovereign bond sell-offs. Abe is expected to pacify concerns about the economic impact of the tax hike with additional stimulus spending of up to Y5 trillion [$50 billion].

Week Ahead

While markets will be focusing on the Fed’s meeting, there is also the release of US industrial production data on Monday, consumer price index inflation figures on Tuesday and the Leading Economic Indicators report on Thursday. In Europe, the key release is the German ZEW economic sentiment survey on Tuesday, while the nation will go to the polls at the weekend as Angela Merkel is expected to retain her position as Chancellor with the makeup of the ruling coalition still unclear.

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