The employment report produced a modest upside surprise with a gain of 203k jobs in November, remarkably close to my estimate of 211k from yesterday, which I might as well enjoy because it will never happen again. In addition, the unemployment rate fell to 7% while the labor force participation rates ticked up 0.2 percentage points. Smells like a tapering report. And with that in mind the market reaction to the news should please Fed official, as bond markets were flat while stocks gained. That too should be something of a green light to taper. I can't help but think, however, that today was something of a goldilocks days for markets, because while the labor report was solid, both headline and core inflation are still headed south. How will the Fed react to the inflation numbers? That seems to be the real question.
In my opinion, the employment report confirms what I said yesterday: The trend of improvement in labor markets remains intact. Indeed, on a twelve-month basis nfp growth is very, very steady:
In the context of the Yellen charts, the steady nfp growth is contributing to a similarly steady decline in the unemployment rate, while the the hiring and quit rates are barely edging higher:
The drop in the unemployment rate reveals the challenges with the Fed's forward guidance. As Victoria McGrane at the WSJ notes, Federal Reserve Chairman Ben Bernanke gave a clear signal earlier this year that the Fed expected its bond buying plan to be wound down by the time the unemployment rate hit 7%. We haven't even started the taper yet. I tend to think the 7% marker was the single biggest communications failure on the part of the Fed, and contributed greatly to the bond market volatility earlier this year. Of course, it is an error the Fed will never admit to.
The steady recent gains in job growth coupled with the decline in the unemployment rate certainly put tapering on the table at the next FOMC meeting. But a policy move at that point seems premature. The issue of tapering is currently wrapped up with a host of issues as noted by Jon Hilsenrath at the WSJ:
Fed officials are likely to debate at their December 17-18 meeting whether to go ahead and pull back on the bond-buying program then or wait until the January 28-29 meeting, Ben Bernanke’s last as Fed chairman, or even later. Waiting until January will give them a little more time to confirm their increasing optimism about the economy and more time to finalize their exit strategy from the bond program and prepare markets for how they’ll proceed. They still have lots of questions to answer about the overall thrust of their policies and how they communicate their plans. Some officials want to put a cap on the overall amount of bonds they plan to buy, rather than leave it open-ended. They’ve also been debating for several months whether to once again alter their guidance to the public about when they’ll raise short-term interest rates.
I tend to believe that they will want to firm up their communications stance prior to tapering, so I have tended to push my tapering expectations into next year. Moreover, the Personal Income and Outlays report leave me cautious about a December taper. The data don't suggest an acceleration of household spending activity:
More worrisome is that inflation continues to fall:
And some of the improvement we saw earlier this year has faded:
It seems premature to expect tapering while inflation is still trending down. Indeed, Chicago Federal Reserve President Charles Evans expressed some caution today:
The official, a voting member of the monetary policy setting Federal Open Market Committee, also said he was “nervous about inflation developments” describing the data as being “substantially” short of the Fed’s 2% target.
He said the Fed had to be prepared to defend the target from above and below.
I suspect Minneapolis Federal Reserve President Narayana Kocherlakota and St. Louis Federal Reserve President James Bullard with have similar concerns. If ultimately everything hinges on price stability over the long-run, the inflation decline should be very disconcerting to the entire FOMC.
Altogether, we have the makings of a very contentious FOMC meeting. Consider the issues at hand:
- The Fed will update their forecasts, which will have an impact on their policy stance.
- Do they focus on "stronger and sustainable," "progress toward goals," "dual-mandate", or "cost vs. efficacy" when assessing the large scale asset purchase program?
- Taper or not? When they taper, do they switch from data-dependent policy to a calendar-dependent policy?
- How do they balance the labor market improvement versus the inflation rate deterioration?
- Leave the current thresholds in place? If so, do they enhance forward guidance? Do they put in place an inflation floor?
- Cut the interest rate paid on reserves?
I don't sense broad agreement among FOMC participants on any of these issues. And all of these issues appear to be tied together in the context of an overall strategy for monetary policy, which means agreement and action on just one item leaves open the door for future conflict and communication failures. It seems too much to expect the December meeting to produce sufficient agreement to justify changing policy; instead, it seems like the best we should expect is that they lay the groundwork to next year's policy path.
Bottom Line: The employment report raises the odds of a December taper. But does the inflation report lower the odds by the same amount? Seems like that is a recipe for bond market stability. Overall, I tend to believe the range of contentious issues yet to be decided on leaves the odds of tapering below 50%. You kind of have to throw-out half the dual mandate, or make an argument that tapering is about labor markets only, to pull the trigger on tapering with inflation still trending down. That seems like it should be a problem for the FOMC.