Federal Reserve Chairman Ben Bernanke took many of us to the woodshed today with the unexpected decision to delay tapering until a later date. I am still processing the outcome of the FOMC meeting, and I suspect I will still be processing it a week from now. At the moment, I am wary of overreacting to this meeting, fearing the possibility of being slapped around again at the next meeting. So for the moment I am going to put aside the explanation that the Fed wanted "to send a message" to markets about who dictates monetary policy. Same to for the idea the Fed' s reaction curve has shift measurably. Instead, I think it best to keep it simple - the Fed decided they didn't have enough evidence to expect the current momentum, such as it is, would be sustained and consequently decided to hold pat.
Danny Vinik presents his take of this story, concluding that most analysts did not take a sufficiently literal view of the June FOMC statement:
The Fed also upgraded its economic forecasts and in the press conference, Bernanke repeatedly emphasized the improvement in the labor market...Interest rates on the 10-year Treasury note skyrocketed while stocks and gold both fell. The market took it all to mean that easy money was coming to an end soon...Except that wasn’t what Bernanke or the Fed was trying to say. They were trying to say that if economic data continues to come in positively, then the Fed will scale back its bond-buying program. But only if the economic data is good.
Vinik concludes that the data did not come in positively, and thus we should not have expected tapering in the first place. I think there is a risk in underestimating the Fed's tapering resolve in adopting that view. It depends, I think, in how you interpret this section of the FOMC statement:
Taking into account the extent of federal fiscal retrenchment, the Committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program a year ago as consistent with growing underlying strength in the broader economy. However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases.
I think this means that, in general, the data was broadly consistent with the Fed's expectations. That is, we weren't reading the data wrong. They just decided that they could wait until longer before initiating the taper. And why might they want to do so? Two reasons:
Household spending and business fixed investment advanced, and the housing sector has been strengthening, but mortgage rates have risen further and fiscal policy is restraining economic growth.
The fiscal policy issue is significant. Indeed, it has always somewhat of a mystery why the Fed opened up the possibility of a tapering in September given that there is no way they would have sufficient data to fully assess the impact of fiscal contraction. They seemed to have been content that the private sector was grinding forward despite the contraction. What's different today? It may be simply that this issue suddenly became more important in the last week as the Republican party increasingly looks to be willing to commit political suicide over the Obamacare issue, and willing to take the economy with them. But it also might be the realization that with inflation still low, there is no rush to taper given fiscal policy uncertainty regardless of the budget/debt debate in Congress.
The higher mortgage rates, and related financial tightening, are also at play. But I think we can be excused to a certain extent for dismissing this as a relevant issue prior to this meeting. Policy makers did not seem to be particularly concerned about the increase in rates until today. Indeed, Bernanke in his press conference today argued that higher rates both removed froth from the market and reflected expectations of stronger growth.
The latter explanation, however, is challenged by the Fed's small downgrade to the GDP forecast. Overall, the forecast has not changed dramatically. Instead, the proximate cause of higher rates was the growing chatter of tapering in the Spring culminating with Bernanke's press conference in June. In short, just talking about tapering was tightening, and that tightening thus eliminated the need by immediate tapering. But then if rates ease back, will the Fed will turn its attention back toward tapering? Nice little circle the Fed has trapped itself in, no?
Worse yet, the Fed, or at least Bernanke, does not want to assume any culpability for that tightening. He seemed to imply that it wasn't his communication policy that was wrong, it was just our listening ability that was a problem. On this, I find myself siding with Justin Wolfers:
This whole taper debate is one that should never have happened. It’s the result of a failed communication strategy.
I am willing to accept that analysts, including myself, didn't sufficiently take the fiscal story or higher rates into account when divining this meeting, although I think the Fed lulled us into submission on the latter issue. But really, if the Fed is being transparent with its communication strategy, should every other meeting result in a 15bp move in Treasuries? Bernanke's "it's not me, it's you" story falls a little flat, in my opinion. They are clearly muddling their message.
In short, it seems that if the Fed now sees higher interest rates rates as undermining their forecast, they need to recognize that they dropped the ball; talk of tapering was clearly premature. We thought is was a data dependent policy and the tapering talk began long before any data suggested it was necessary. Once again speaks to their bias against quantitative easing. They want out of the program, but are finding it to be a roach motel.
Finally, notice the increasing challenges surrounding the thresholds, particularly the unemployment rate. Bernanke backed off his 7% threshold today for tapering, but he almost had to with that number staring him in the face. And interestingly they held their unemployment forecasts steady even though the unemployment rate has been steadily dropping and is already in their end-of-year average range. The problem, I suspect, is that it is hard to maintain a dovish message given falling unemployment rates in the context of the thresholds. The problem is made worse because they can't decide if falling unemployment rates reflect real improvement in the labor market or cyclical decline in labor force participation. So at this point the unemployment threshold look to be defunct. They need a new, meaningful threshold. Or will the Fed use unemployment when they support the story they want to tell, and put it away when it is inconvenient. It is certainly going to be a communications challenge when you base policy on a variable you don't really understand.
Bottom Line: I am wary about reading too much into today's event, fearful that the next batch of Fed speakers is going to emphasize that they are very close to tapering. I will be chewing on this one for some time. Bur for now, if the Fed is staying true to their data story, the six weeks between now and the October meeting look to be too short to fully evaluate the impact of fiscal contraction and higher rates. December looks like the earliest date now, which puts the initial tapering in line with what I think would have been the consensus view had not the FOMC accelerated expectations of tapering earlier this year.