Three Fed Tapering Scenarios?
The U.S. Federal Reserve’s Open Market Committee concludes one of the last three meetings of this year on Wednesday, with the policy announcement due at 2 p.m. EDT, and Chairman Ben Bernanke to speak at 2:30 p.m. (Watch the live media briefing here.)
Key Fed players have indicated time and again that a cutback in its $85-billion-a-month bond purchase program isn't a done deal in September. The disappointing August jobs report further clouded the picture.In all likelihood, the Fed will start trimming its asset purchases but don't expect anything dramatic. Why? Because as Harlan Green of Populareconomics.com notes, deflation is the danger:
Sam Wardwell, investment strategist at Pioneer Investments, laid out three possible outcomes of the September FOMC meeting and a handful of questions he said he’d like to ask the chairman.
First up, a human interest question about the former Princeton economics professor himself. With Bernanke leaving the Fed in January, Wardwell asked the question that’s on everyone’s mind -- “Will we ever see you in a classroom again?”
“A lot of people will and a lot of people won’t. Both Bushes went radio silent after they left the presidency,” Wardwell said. “Is he [Bernanke] planning to be radio silent for the next 10 years, or is he going to actually talk about what he learned and try and educate people on what the lessons were?”
Now, back to the serious stuff.
Scenario I - Taper-Lite: $10 billion
(Possibility: 60 percent)
Wardwell’s call is in line with the consensus. Nearly three-quarters of the 69 economists polled by Reuters following the August jobs report expect the Fed to announce this week that it will trim its asset-purchasing program by $10 billion a month. That compared with just 25 of 41 economists in a poll conducted last month.
Why: Credibility. Central banks put huge weight on credibility, and credibility is earned through consistency. Consistency and credibility are especially important when forward guidance is critical to what the Fed is doing.
“My concern would be if they don’t start [tapering] at all, the bond market might say, ‘Oops, the Fed has blown a bond bubble, the Fed is now panicking, the Fed blinked,’” Wardwell said. “And if the Fed blinks, the market is going to lose confidence in the Fed.”
But given how far the bond market has moved, Wardwell thinks the Fed will be inclined to do “taper-lite” rather than piling on to a bond market which has been selling off in the past couple of weeks.
Question for Bernanke: “In your modeling, how much of a drag do higher interest rates have on the economy?”
According to Wardwell, the Fed’s answer can give him a taste of whether the Fed is more likely to taper "heavy" or "lite" going forward.
Wardwell thinks Bernanke would give the audience an Alan Greenspan-style “mumble, mumble, mumble.”
“We are data-dependent. I don’t know whether I’m going to need sunglasses or an umbrella next Tuesday, I’ll make that decision when I get there,” Bernanke might say.
Greenspan, who ran the Fed from 1987-2006, was known for making long, vague statements on future changes in Fed policy. “If you understood what I said, I must have misspoken,"” Greenspan famously told a senator once.
“The Fed is very careful in its communication, and I’m not sure how much you’ll really learn from Bernanke by asking these questions,” Wardwell said.
Scenario II - Taper Delayed: $0 billion
(Possibility: 20 percent)
When the FOMC meeting concludes Wednesday, policymakers might decide to postpone reductions until a vague date.
Why: The case for not tapering at all (in September) is that the bond market has sold off so hard that the Fed will need to effectively talk the market down again.
“By actively deferring the tapering, the Fed is sending a message, ‘I really don’t want rates to go up,” Wardwell said. “The market will read that body language.”
Question for Bernanke: "Why didn’t you start [tapering]? What has gotten you so scared that you have changed your mind? What do you know that I don’t know?"
According to Wardwell, there’s not enough data coming out between now and the October meeting to really change anything. The August jobs report was a shock, no question about it. But August tends to be a seasonally weak month for hiring.
“The data that came in says to me that the economy is less vulnerable to a setback than the data was 60 days ago. So if anything, I’d say that the case for continuing QE has been diminished rather than strengthened by the economic data that’s come in,” Wardwell stated.
“Not tapering would be scary,” Wardwell added. “It would suggest the Fed knows something really bad, and I would really want to know what that was.”
Scenario III - Taper-Heavy: $20 billion or more
(Possibility: 20 percent)
The Fed said in its July statement that “almost all” of the FOMC members agree that they're “broadly comfortable” with the idea of starting tapering later this year and being finished by the middle of next year. When the Fed says “almost all,” that really means it’s inscribed in stone.
Why: “The reason for heavy tapering would be that in fact the Fed is really confident that the economic data is good and that inflation is not a problem, but that the bond market really needs to normalize. And that it really wants to get out of the QE business as quickly as possible,” Wardwell said.
A research paper presented at the annual Kansas City Fed symposium in Jackson Hole, Wyo., made a good academic case that “the effect of QE3 was blowing a bond market bubble but not stimulating the economy,” Wardwell said.
“It’s sort of like if you’ve got somebody who’s addicted to painkillers, get them off the painkillers,” Wardwell added. “If [QE3] is not doing any good, stop doing it. That’s the case for taper heavy.”
Question for Bernanke: "What’s the Fed’s cost-benefit analysis of QE3? Let’s assume that QE3 goes away at some point, what’s the probability of QE4 if the economy backslides?"
“Bernanke might say, ‘Yes, you know ... QE3 wasn’t worth it,’ in which case you don’t get QE4,” Wardwell said. “But if he said, ‘Hey, it was a very successful program, I’m glad we did it.’ That suggests that QE4 is still in the quiver if the economy slips back again.”
While Wardwell thinks QE1 might have been a good idea, he's skeptical about QE3.
“Let me just put it this way. You are in an auto accident, you are in an ambulance, you are in an emergency room, you are on an operating table, if they haven’t given you painkillers yet, you’ve got a big problem,” Wardwell explained. “Two years, four years later, if you are still on painkillers, you’ve got a big problem.”
“If you go back to May and you see Dow Industrial companies issuing long-term bonds with coupons below the dividend on their common stock, there’s no way that makes sense in an efficient market,” Wardwell said. “'Bubble' is the word that I would use to describe that kind of irrationality.
“I think the Fed is blowing a bubble and I hope they don’t come back with more [QE4],” Wardwell said. “If the Fed does come back with QE4, it’s probably going to be a policy mistake.”
Why such non-existent income growth for Main Street, and why do we need more inflation? The answer has to be that very few are benefiting from this economic recovery with heavy debt loads still holding back both government and consumer spending. The top 10 percent of earners took more than half of the country's total income in 2012, the highest level recorded since the government began collecting the relevant data a century ago, according to an updated study by Saez and Piketty.Paradoxically, Green argues for no Fed tapering because very few benefited from the recovery but QE has exacerbated income inequality. He is absolutely right, however, deflation is the danger and debt loads are crushing consumers. Also, if we get an emerging market crisis, deflationary headwinds will only intensify, which is exactly what the Fed and other central banks are desperately trying to avoid.
"These results suggest the Great Recession has only depressed top income shares temporarily and will not undo any of the dramatic increase in top income shares that has taken place since the 1970s," Mr. Saez, an economist at the University of California, Berkeley, wrote in his analysis of the data.The income share of the top 1 percent of earners in 2012 returned to the same level as before both the Great Recession and the Great Depression: just above 20 percent, jumping to about 22.5 percent in 2012 from 19.7 percent in 2011, said their study. And that is the real problem. Consumers cannot spend what they cannot earn, so the Fed should stop the taper talk.
Consumers cannot earn more and inflation cannot rise unless some economic policies are reversed, such as the incredibly skewed tax laws. The majority of those wage and salary earners' effective tax rate is something like 30 percent when payroll and income taxes are taken into account. And what was Mitt Romney's? Something like 14 percent for those 2 years he was willing to disclose.
I invite my readers to once again read the recent comments Brian Romanchuk is posting on his blog, Bond Economics. Brian explains in detail why higher debt-to-GDP means lower bond yields, why with Summers out we can expect more of the same and why inflation is contained (again):
The U.S. CPI data for August was somewhat below expectations (BLS web page). A low level of CPI inflation is not too surprising; the only real surprise in inflation since the financial crisis is the lack of deflation, given the large amount of excess capacity in the economy.Brian is right, in this environment, the outlook for growth, not inflation, will drive bond yields higher. And unless growth comes roaring back, there is no reason to believe that bond yields will explode up.
The chart above shows the annual rate of change for the CPI, and average hourly earnings since 1965. The close relationship between wage and CPI inflation is to be expected; labour costs are a very large proportion of the cost of most good; the most notable exception is gasoline (which generates a significant portion of the volatility in the CPI). The amount of slack in the labour market would appear to indicate that it will take a long time for inflation to perk up. Therefore, the main directional driver for the bond market will be the outlook for growth, not inflation data.
Below, Daniel Alpert, author founding managing partner of investment bank Westwood Capital, discusses why oversupply in economies throughout the world creates grave risk of deflation. Keep this in mind as the Fed begins to trim its asset purchases.