As if the Federal Reserve did not already have enough on their plate in sorting out the confusion over their near term policy path in the wake of the decision not to taper at their September meeting, the almost criminal dysfunction on Capitol Hill is now also pushing the question of a deepening fiscal retrenchment to the forefront.
There will be another round of Federal Reserve speakers, including Chairman Ben Bernanke making some introductory remarks to a Community Banking conference in St. Louis, hitting the tapes starting tomorrow. Hopefully they will give the markets some greater clarity than last week’s virtual cacophony of conflicting messages by Fed’s officials which left the markets and public as confused as ever. And now they will undoubtedly be asked about the fiscal impact on the outlook and monetary policy as well.
First, though, everything from here must be taken against the backdrop of the Federal Open Market Committee’s decision at the September meeting to back away from a first taper in the flow of its $85 billion a month in bond purchases.
The September Meeting
Both the mixed at best if not weakening data and the immense fiscal uncertainty on Capitol Hill weighed heavily on the hesitation to that first taper, which, in hindsight, is looking increasingly like a good call in light of the current mess on the Hill. But at the September meeting itself, it was ultimately the unfortunate own-goal of the tightening financial conditions brought on by the Fed’s “premature” signaling to the tapering that tipped the consensus to wait on the withdrawal from QE. It was indeed a borderline call, but aside from a quartet of displeased hawks, the decision not to taper ended up as a widely felt consensus led by the Chairman and Vice Chair both.
In particular, that decision was not driven by concern over the yield levels or the tightening going into the meeting, but rather by the concern that there was an even greater risk a weakened and mis-sequenced forward policy guidance could limit the Fed’s ability to dampen a continued tightening of conditions if the start to the tapering of QE was confirmed, however minimal the amount. In that sense, the two most revealing words inserted by Federal Open Market Committee into its September meeting statement was that the “tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and the labor market.”
Indeed, in reviewing the way the open-ended regime was rolled out since its launch in September and December last year, it was clear in the pain of hindsight in pushing deeper with untried unconventional policy, that mistakes were made along the way which, to varying degrees, may have undermined the assumed potency of the forward guidance on rates. And nowhere was that more so in what is now conceded as probably a premature signaling to the taper in early summer. Indeed, there is also no small amount of thinking that if QE was meant to be a boost to the momentum of the recovery and to reinforce the potency of the rates guidance, then how quickly could the intertwining of the two be severed anyway?
So by the time of the September meeting, with the data and Congress being uncooperative in providing at least some clarity as a backdrop, the FOMC concluded in a fairly strong consensus that they could not prudently take the risk a sustained rise in yields, especially in mortgage rates, could stall a sub-par growth at a very vulnerable stage of the recovery. And as something of an ironic twist to the frustrations over delinking QE from rates, pulling away from the taper pushed yields back down to where most of the Fed modeling was putting them, albeit already well into the tapering process.
If the smart play would have been to go ahead with a minimal taper since the market was already positioned for it, not to taper after taking all these factors into account, and however much they knew it would be damaging in the near term to their communications credibility, was the more honest one.
A Re-setting of the Forward Guidance
In the wake of the dramatic September meeting decision, the priority of the communications strategy going forward — and it is still evolving — is now to “re-set” the sequencing in what Chairman Bernanke began describing this summer as “changing the mix” of policy instruments. In effect, the public messaging by a core of the dovish-inclined FOMC majority will be to layer an ever greater accent on the lower for longer rates guidance before another approach is made on winding down the bond purchases.
This post-September “re-set period” of weeks and probably several months is likely to be highlighted by a collective effort to reinforce the forward guidance by pointing to the gradually sloping trajectory in rates hikes as underscored by the most recent “dots” of the end of year 2016 fed funds rate projections. Chairman Bernanke tried in vain to highlight just that in the post-meeting presser but it was drowned out by the attention on the no taper shock; New York Fed President Bill Dudley also pointed again to the gently sloping trajectory of the 2016 dots in one of his speeches last week, and other Fed speakers this week and through October are likely to stress the same.
Other reinforcing measures, such as the lower 1.5% band to the 2.5% safeguard inflation threshold, or a downward adjustment to the 6.5% unemployment threshold, are also being weighed. Any changes to one or the other or both, though, is probably more likely for later this or early next year rather than as soon as October.
On the former, for instance, the 2% inflation target is already symmetrical on either side over the medium term framework. So adding a lower band could be a bit redundant, but still, it could prove to be one of the “sensible modifications” Chairman Bernanke noted in the September presser, by helping to reinforce the case that rates will simply not be raised if the various price measures point to a persistent sub 1.5% path.
The questions over a downward adjustment in the 6.5% threshold have already been well telegraphed. The issue here is not just whether the credibility of a single unemployment headline rate would be damaged once changed — why not again and again? — but its usefulness is obviously under threat when there are so many other measures of labor market health, especially the labor participation rate, that are and can point in opposing directions.
The Outlook for a Deepening Fiscal Retrenchment
In any case, however, the pressure to reinforce the lower for longer rate guidance may lessen, albeit for bad reasons, in that low rates for a hell of a long time may soon be a given if the disarray on Capitol Hill goes from bad to worse. Fed officials are going to raise the issue and will certainly be asked how they see fiscal policy influencing the near term path for monetary policy in the upcoming public forums this week and next.
Aside from a highly unlikely “Come to Jesus” moment for Congress in which deals are quickly cut and discretionary spending is suddenly boosted over the next few quarters (with entitlement and tax reform balancing it out in the medium term no less), there is little doubt another layer of fiscal drag looms large on the near horizon. And that will almost certainly feed into the Green Book forecasts prepared for the October meeting as well as the guidance in the Summary of Economic Projections for the December meeting.
Again, the speeches by New York’s Dudley last week provide a usual guide to where the Fed’s anxieties lie. For one, and it is something we do expect other like-minded FOMC members to pick up on, the persistence of the fiscal ‘headwinds” may slow the pace at which the economy can claw its way back to a trend growth rate, and by default, for the equilibrium level of interest rates to reach an assumed neutral level. In other words, the optimal policy path of lower for longer rates and a slower than normal rate trajectory is looking less unlikely or risky.
But secondly, and more urgently, the Fed is clearly worried about the immediate impact of the shutdown, even if only a few days and certainly if prolonged, in taking a whack out of consumer spending and especially the already lackluster business investment spending — the useful Atlanta Fed Macroblog site already notes business R&D spending over the last five years is barely 1.1% compared to the 50 year average of 4.6%.
But looking beyond how the CR and debt ceiling battles play out, perhaps the graver anxieties are just beyond the near horizon. At some point before year-end, Congress will still have to deliver a budget, and that means the fiscal uncertainty will only be extended to year-end and probably into next year. Indeed, there is a growing recognition the lagged effects of the fiscal retrenchment may spill over well into next year as well.
If there is no deal before year-end to lift the sequester or to get out from the draconian cuts of the next few years under the Budget Control Act of 2011, the fiscal retrenchment will only deepen, not lessen, next year. And, of course, this would be happening exactly when the Fed would most dearly like to see some of the enormous strain on monetary policy being relieved by a more supportive fiscal policy that would in turn make its efforts to begin unwinding QE3 that much smoother and easier.
And, Finally, the Taper Question
As to the taper itself, it would be fair to say a consensus on either its trigger or pacing seems unlikely before the October 30-31 FOMC meeting, and indeed, that would be almost impossible under the current confluence of political events, confusing data, and the need for the guidance reset that a first taper would even be considered at the meeting.
Instead, we suspect the focus for now will be on what new or additional communications signposts could be unveiled to guide market expectations and to dampen volatility as much as possible. And at least in the near term, it will be difficult to even fall back on the “data-dependent” path — and to be fair, Fed officials have always really meant more accurately “forecast-dependent” — because the prism through which the data over the next few months will be viewed is going to be skewed with an even wider variance than usual due to the distortions of the shutdown. And that, of course, is even assuming there will be any data points if the shutdown becomes prolonged.
The increasingly influential Board Governor Jeremy Stein has already brought up an intriguing idea for a more mechanistic, rules-based guidance on the QE tapering path. But for now that seems unlikely, and the idea may more than anything else provide a good indication of how widely the reassessment lies over how, when, and if the Fed will ever break free of the “QE trap” many in the market see, but which most Fed officials refuse to accept to be the case.
And again, even without the dislocations of the government shutdown and the high noise/low signal value of the data over the next month or so, any tapering in any case would still need to be preceded by a far greater, and unquantifiable, degree of confidence the tapering is not taken as a signal on interest rate policy.
Additionally, since most Fed officials would love to simply reverse the narrative away from the first taper timing to how long the bond buying could last, the bar to a first taper is in that sense also higher than it was at the September meeting inflection point. Yes, there are those lingering, terribly nagging questions over the potential difficulties in managing the eventual Exit back to normalized interest rates with a hugely bloated balance sheet. But those concerns, for now, will simply have to be put on the back burner; what is another few hundred billion dollars of excess reserves between friends at this point anyway?
While we are reluctant to even speculate at this point on the timing of a first taper, even December is looking problematic and we would wonder if the QE question is rapidly becoming an issue for the new Chair in March 2014. Indeed, we suspect the size of the open ended bond purchase regime may reach a stock of at least $1.2 trillion or more in additional accommodation before its flow is brought to a close.
At the same time, though we are not sure of the signaling effect calculations, we still have a feeling that with even with the later start to the tapering process, the Fed could come by then in quicker, larger chunks that would bring the QE to an end at or close to Chairman Bernanke’s signaled mid-2014, give or take a meeting.
At the end of the day, it will be the end point and the total stock of accommodation that should matter, not its start, especially if by then the FOMC is successful in the re-set of its cornerstone forward guidance on rates and the trajectory of the optimal policy path so championed by the likely next Fed chair.