Two Issues for the Fed: How and When

Federal Reserve Chairman Bernanke testifies before the Joint Economic Committee of Congress tomorrow. The market is anxious for the Chairman to weigh in on the recent comments suggesting that even some like-minded regional presidents like Chicago's Evans seems to be warming to the idea of tapering off purchases.

It is one thing for the more hawkish members, several of whom have never felt comfortable with the latest iteration of quantitative easing, to talk of slowing purchases, but it is another thing for some of the more dovish members to talk in this vein. Yet we suspect there is less than meets the eye. With the stock market extending its advancing streak to near 200 days without a 5% pullback and what Bernanke has called "the reach for yield" has driven the industry index of below investment grade yields below 5% for the first time; it is incumbent on Fed officials to demonstrate their vigilance.

To this end, the leadership needs discuss the conditions that would allow it to taper off its purchases. The Fed has been reluctant to provide much guidance in this regard, unlike the inflation and unemployment thresholds cited for interest rates. How the Fed exits from QE3+ is generally understood to be a slowing of purchases, probably of the mortgage-backed securities first. In a recent much-vaunted Wall Street Journal article, how the Fed exists QE3 was said to be "careful" with "potentially halting steps".

Arguably the more important issue is when and here the Wall Street Journal article was even less revealing, noting that it is still being debated. Although one non-voting Fed president talked about tapering off purchases as early as next month's meeting, this does not appear to be consensus. Instead, there is a consensus to wait for more economic data. More data seems to mean another quarter or so.

Some officials, including Chicago Fed's Evans, who was among the most dovish members, noted that the economy is "improving quite a lot", but wants to see if the economy sustains its momentum after having experienced other episodes of growth that proved temporary. Employment growth is understood to be among the most important real economy measures. 

It is true that the 3-month and 6-month average non-farm payroll growth is just about the 200k threshold that Evans, among others, has cited.  However, this overstates the strength of jobs growth.  Consider that we have four months of data for this year.  In three of the months, non-farm payrolls were 165k or lower.  In one month, February, there was an outsized jump of 332k jobs, which skews the averages.  However, with the May report on June 7, the February figures drop out of the 3-month moving average calculation. 

Fed officials, and especially Bernanke who as a student of the Great Depression, is particularly sensitive to deflation risks, a few more months of data on inflation measures may also be helpful.  The Fed's preferred inflation measure, the core PCE deflator stood at 1.1% in March.  Only in two of the past nine months, has the deflator risen by more than 0.1%.  

Some officials, like Evans, suggest that the decline in inflation may be transitory.   Looking at the base effect for the year-over year measure, in Q2 last year, the monthly increase averaged 0.13%.   As these drop out, the core PCE deflator will likely fall below 1%.  Such a low inflation reading would risk deflation and would seem to argue for continued easing of monetary policy.

In addition to employment and prices, there is a third consideration: fiscal policy.  Bernanke has commented previously on the fiscal drag.  However, the US budget position is improving considerably faster than expected.  Last week, the Congressional Budget Office updated its budget outlook.  

Assuming no changes in the current laws and plans regarding taxes and spending, the FY13 budget deficit is expected to now shrink to about $642 bln, the smallest since 2008 around 4% of GDP.   This is less than half the 2009 shortfall (~10.1%) and an impressive decline from the 7% shortfall in FY2012.   To appreciate this consider that the UK government which has been committed to austerity since getting elected in 2010 has seen no change in public borrowing as a percentage of GDP (~7.5%). 

The US public debt/GDP ratio is projected to begin falling next year.  The CBO estimates that the FY2015 deficit will fall to almost 2% of GDP.    The less accommodative fiscal stance may also encourage the Fed's leadership to take their time.  The US economy remains fragile and reducing both monetary and fiscal accommodation at the same time may not be desired.   

Bernanke's testimony tomorrow takes place before the FOMC minutes are released.  Bernanke's comments are more important of the two events.  However, recall that the FOMC statement released on May 1 contained one notable tweak and that is that "The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes."  This symmetry contrasts with previous talk that focused on tapering off the purchases.  In turn, this suggests some doves pushed back.  

Data released since the meeting has generally been soft and/or disappointing.  This includes non-farm payroll report, which included a decline in aggregate hours, surveys for May, softer auto sales, industrial production and manufacturing and housing starts.  The resilience of consumer confidence and retail sales were the exception. 

On balance then, we suspect Bernanke will recognize, as the FOMC statement did, that the economy is growing at a moderate pace and that decisions on the pace of asset purchases is a function of changes in employment and inflation.  It serves his interest to indicate it is data determined and that more data is needed.  If this does in fact materialize, we suspect it would be supportive for US Treasuries while weighing on the dollar.  To the extent that the FOMC minutes show that there are some at the Fed who think it should be doing more, it may also push the markets in the same direction.