In addition to other activities, I spent a fair amount of the weekend puzzling over how we ended up at this tapering debate in the first place. After all, the data hasn't been terrible, but it hasn't been exactly blockbuster either. To be sure, we started the month with some promising data, but the employment report turned out to be yet another of the lackluster reports to which we have become accustomed. In short, nonfarm payrolls continue to grind upward:
The twelve months haven't seen any huge disappointments, but also only one blowout month. Moreover, underemployment indicators are not improving at any rapid pace:
None of this is new, and none of this prevented Federal Reserve Chairman Ben Bernanke from outlining a QE exit path on June 19th of this year. But why outline that path in the first place? I suspect it comes down to this sentence from the FOMC statement:
In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.
Bernanke seemed firmly committed to a 7% unemployment rate as a trigger for ending asset purchases - that apparently represents progress toward meeting economic objectives. Indeed, at that current rate of decline, we will be hitting that target very early in 2014:
If 7% unemployment is actually a relevant level, best to start tapering sooner than later. Moreover, the unemployment decline is occurring in the context of a GDP path that is generally following expectations:
GDP growth decelerated as expected with fiscal contraction; if the forecast continues to hold true, expect GDP to accelerate in the second half of the year. So, from the Fed's point of view, one could see where they are making substantial progress toward their objectives (the unemployment rate) in the context of a forecast that is generally consistent with expectations. Moreover, there is also the additional context that the costs of QE may be rising in the form of financial instabilities.
But what about inflation, or lack there of? Well, notice that the Fed is arguably in something of a tight spot. If you have a Phillips Curve view, then unemployment is quickly approaching a level in which upward pressure on inflation would be expected. And the Fed would certainly want to begin removing accommodation prior to seeing that pressure emerge. And time to remove that pressure is growing short, at least as indicated by the path of unemployment. So you can see where September becomes something of an important time if you want to gradually back away from asset purchases. The longer you wait, the longer you risk having to go cold turkey on asset purchases.
And if you thought Bernanke set off some fireworks by discussing tapering in June, imagine the reaction if the Fed was to pull the plug on asset purchases at the last minute with some blowout data coming in the door as the impact of fiscal contraction fades.
Moreover, you can also now see another problem. It makes sense to confirm the waning impact of fiscal policy prior to tapering. But we really won't see that data until deeper into the fourth quarter, at which time we can expect to be right on top of the 7% unemployment mark. Again, does the Fed want to be in the position of having to suddenly pull the plug on QE?
But, but, but, you say, look back at those underemployment indicators. Surely inflation is not a realistic threat at 7% unemployment, or even 6.5%. The Fed has already covered this, however, in its forward guidance about interest rates:
In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.
If need be, the Fed can address underemployment by holding rates near zero for longer than expected. In affect holding the level of accommodation constant for now, but adjusting the mix to ease the eventual transistion to higher rates. And perhaps to alleviate some financial distortions specific to quantitative easing as well.
So I think, at least in the context of the above, Bernanke's push for tapering become more understandable. But will they follow through on tapering September as expected, or push it back until later in the year? You can make an argument from the rise in rates, the data, and the Fedpeak that they will push it back. But you can also make the argument that they may as well get the ball rolling now because the adjustment to a new regime has already occurred.
Note that despite the data and the Fe speak, rates remain stubbornly high relative to the pre-June 19th period. On that date, Bernanke firmly reset expectations. Unless the Fed is willing to accelerate the pace of asset purchases, it is difficult to see the Fed reversing June 19th. So that leaves the Fed in the position of either tapering in the near future, which is largely expected and thus should not have a significant impact on rates or delaying the tapering and running the risk of an abrupt end to QE without having a significant impact on rates. After all, if they pass on September, then it is easy to see an entrenchment of expectations that December is the date. Indeed, if financial market participants suspect that a delay now means a faster reduction of accommodation later, a pass in September could have the perverse result of sending rates higher rather than lower.
Bottom Line: There is considerable uncertainty around a September date to begin taper. Fedspeak and recent data have left me much less certain. But I can see how the steady decline in the unemployment rate combined with a Phillips Curve view of the world puts the Fed in the uncomfortable position of possibly having to reduce accommodation prior to a being fully certain if their forecast is accurate. Delay in the context of an accurate forecast could leave them tightening much more aggressively than currently expected. Hence why I tend to see the bar to tapering as low, but the bar to ending zero rates as high. Moreover, the cost to tapering is arguably now low because the increase in rates is already behind us; September or December isn't meaningful in the big picture anymore. Overall, I still tend to lean toward September over December, with the lack of a press conference being the reason to not settle on October.