Looking back at the last month, it seems evident that we moved through a policy inflection point. Eventually, improving economic activity would prompt the Federal Reserve to begin normalizing policy. To be sure, the process is not likely to be quick, but it will happen. As labor markets improved, housing prices rose, and asset prices climbed, policymakers would start to believe that the costs of quantitative easing would be rising relative to the benefits. Thus the first stop on that journey to normalized policy would be to scale back the pace of asset purchases.
At this point, market participants have largely absorbed the news the quantitative easing would be phased out in the months ahead. Once this became evident, US Treasury securities were no longer a one way bet, and thus the willingness to hold bonds at a sub-2% rate decreased somewhat. As should have been no surprise to anyone, Federal Reserve officials included, rates thus backed up, eventually settling in a range around 2.5%. Similarly, equities stumbled but then regained their footing. That, I think, marks the end of the tapering debate.
How could the debate be over before tapering even begins? I think Joe Weisenthal has the answer:
Maybe the Fed will start slowing its pace of bond purchases in December. More likely it will be September. It doesn't make much of a difference.
But really the story now, with respect to the Fed, is when the first interest rate hike will be...
Other than bragging rights, September or December isn't really important anymore. And to be sure, I am still interested in the political intrique behind Bernanke's move to lay out the tapering. How much did he influence that discussion? And where he get the 7% unemployment trigger? But I suspect the market moving news surrounding the taper - that quantitative easing is not forever, not even for another year - is behind us. At this point, any impact of the data on the pace of tapering is really not that important. What is important, however, is the impact of data on the lift-off from the zero bound.
Indeed, an emphasis on rates is exactly what we can expect from Federal Reserve Chairman Ben Bernanke's testimony this week. He will reiterate the message of last week, that quantitative easing and interest rates are two separate policies. An end to quantitative easing does not imply that the date of the first rate increase has been moved forward.
Thus, the message will be that you shouldn't be expecting a rate increase in 2014 because the Federal Reserve changed its reaction. Bernanke will tell you they did not change the reaction function, and if need be, they may feel compelled to prove it by shifting the unemployment threshold down from 6.5%. Any case for a 2014 rate hike would rest on the premise that the economy takes a dramatically more positive turn than policymakers expect. And note that this would comes as a surprise to Fed officials, who tend to worry not that their forecasts are too pessimistic, but too optimistic.
So what takes us to a 2014 rate hike? At the risk of oversimplifying, I am looking at four main factors. First is that impact of fiscal contraction definitively fades in the second half of this year. Second is that the housing market does not stumble in the face of higher mortgage rates. Third is that the labor market continues to expand such that we see real improvement in measures of underemployment. And fourth is that inflation soon reverses course and trends back to 2%.
That to me seems like a a lot of things have to go right in very short order. I am reasonably confident that the effects of fiscal contraction will fade, and that the housing markets will continue to improve. On the latter point, note that interest rates are only one factor driving housing activity. Please see Calculate Risk and FT Alphaville for more information. As far as the other two points are concerned, I am wary of believing that even after taking fiscal policy and housing off the table, growth will be strong enough to drive the kinds of changes in labor markets and inflation dynamics that would induce the Federal Reserve to being normalizing interest rates in 2014.
Bottom Line: Whether or not the taper happens in September or December, financial market participants have already digested the news that quantitative easing in not forever. For the most part, incoming data is now about timing the next milestone in the process of policy normalization, the first rate hike. Expect policymakers to continue to push back on expectations that 2014 will bring a rate hike. Indeed, it seems a lot has to go right in the data to make that happen.
