From Westpac’s Elliot Clarke, who recently got the Fed untaper right:
In the wake of the FOMC’s September ‘no taper’ decision, we have seen a slew of Fed speakers. While concerns over heightened uncertainty and FOMC communication credibility raised by dissenter Esther George and non-voter Richard Fisher have received the greatest attention, it is the well considered comments of NY Fed President William Dudley and St Louis Fed President James Bullard which are most constructive for the policy outlook.
Likely to draw the ire of market participants burned by last week’s decision, Dudley noted on Tuesday that the September decision was “completely consistent” with the Fed’s June guidance: the Fed had made a conditional pledge to taper if the data supported it and markets had jumped to conclusions, ignoring the erratic and often poor tone of data. While Dudley did not rule out a late-2013 taper, the framework laid out by Dudley on Monday makes it highly improbable.
From the detail of Dudley’s speech, a clear narrative emerges. Dudley (and arguably the majority of the committee) believes that, to date, the improvement in the US’ underlying fundamentals has been offset by the drag from fiscal policy and tighter financial conditions. The consequence is that “we have yet to see any meaningful pickup in the economy’s forward momentum”, a necessary pre-requisite before Dudley would agree to taper.
On fiscal policy, Dudley noted that the fiscal drag (as estimated by the CBO) would be less in 2014, but still significant. He went on to highlight that “the fact that the degree of restraint lessens next fiscal year could understate the actual impact on the economy because the full impact of some of this year’s cuts may not yet have been fully felt”. The example he gives of the delayed activity impact of reduced federal university grants is consistent with the difference between appropriations and actual outlays which we havepreviously highlighted. He also noted the high degree of uncertainty around the fiscal outlook associated with the 30 September funding authority deadline and the subsequent debt ceiling debate. The overarching implication is that the fiscal drag may persist for much longer than previously anticipated by the Fed, and conversely that underlying growth (i.e. absent sequestration) has been weaker than they had hoped.
The second key theme of Dudley’s speech was around the impact of taper talk on financial conditions. As noted by Dudley, “before last week’s partial reversal, the 30-year fixed mortgage rate had risen by about 120 basis points since May to more than 4½ percent… [making] housing considerably less affordable than it was earlier in the year”. Indeed, the National Association of Realtors report that affordability has declined by 25% over the six months to July. Together with the observation that housing has already contributed “significantly to growth”, Dudley concludes “that the impetus to growth from housing may moderate rather than strengthen”.
To us, the above discussion over the effect of taper talk on mortgage rates is consistent with the view that tapering is contractionary. But Dudley went out of his way to state that he believed this is not the case, instead believing it is “simply adding accommodation at a slower pace”. This is a sharp contrast to St Louis’ Bullard who sees the market reaction to the June and September meetings as “sharp evidence that changes in the expected pace of asset purchases have conventional monetary policy effects”. Indeed, Bullard went on to say that “Changes in the expected pace of purchases at the June and September FOMC meetings had the same financial market effects as would have occurred had the Committee been able to change the policy rate path directly” and “Using the pace of purchases as the policy instrument is just as effective as normal monetary policy actions would be in normal times”. Arguably whether one sees tapering as neutral or not is a mute point so long as the associated impact on financial conditions is recognised.
Finally, of key importance to the outlook, there is an underlying theme to both of these speeches (and indeed last week’s statement and press conference) which points to a desire to strongly emphasise that QE is still seen as being effective and that there is no formulaic link between tapering and interest rates. Clearly the Fed is trying to move towards a market view of QE which holds it as a cyclical instrument that can be increased or decreased as needed. It is only after the economy has successfully absorbed the associated financial condition impacts that higher interest rates could be imagined. The conclusion to draw is that one tapering step should not immediately translate into an expectation of QE’s end, but rather a conscious understanding that any subsequent move will depend on a further improvement in the economy. And if instead the economy falters, the pace of purchases may be increased again. Arguably, this has always been the view of the Fed. Markets just got well ahead of themselves.
I agree. In fact all this whining about the Fed’s communications is ridiculous. If the market needs to know exactly what the Fed is going to do whenever it’s going to do it then what’s the point of the market at all?
