To Taper or Not

September 6, 2013

It’s one question whether the Fed will begin tapering this month and an entirely different matter whether that’s the right thing to do at this stage of the U.S. business cycle.

I’m quite confident that tapering will start now and will become much more so unless clear verbal signals emerge in the coming week that there’s been a change of FOMC plans.  Fed officials appear quite concerned that a point has been reached where continued maximum quantitative easing might entail large costs in terms of diminishing benefits and accelerating risks of damaging financial markets.  Communication plays a huge role these days in Fed policymaking, wherein the avoidance of market surprises is paramount.  Investors expect less tapering after the September FOMC meeting, and the fact that this consensus has not been shot down by officials is very revealing.  Officials had hoped for a disconnection in market psychology between a wind-down in the pace of its incremental asset purchases and in the onset of monetary tightening.  Coining the verb “taper” to describe a reduction in quantitative easing was part of the communications strategy intended to create this compartmentalization, but investors didn’t take the bait.  Market interest rates have climbed more sharply than Fed officials had expected or probably desired but not enough to scrap the plan to taper even after somewhat disappointing labor market data.

From an economic standpoint, this seems a strange time to rein in quantitative easing because in many respects the economy was better off a year ago, and monetary conditions are already tighter now than then.  The core personal consumption deflator rose 1.1% in the year to 2Q13, down from a gain of 1.7% a year earlier.  The ten-year Treasury bond yield is 2.94% now versus a September 2012 mean of 1.70%.  Deflating those nominal yields by the PCE deflator shows a rise in the inflation-adjusted real long-term interest rate of 165 basis points.  A six-percentage point trade-weighted dollar appreciation over the span acts like a half-percentage point additional rise in interest rates, and a 16% jump in oil prices tightened monetary conditions even further.  The jobless rate is the single economic indicator around which the Fed has most closely tied future policymaking, and its drop over the past year from 8.1% to 7.3 is hardly inconsequential.  However, that accomplishment is diminished by a current labor participation rate of 63.2%, which is 0.3 percentage points lower than a year ago, and an employment-to-population rate of 58.6%, 0.1 percentage points less than a month earlier and just 0.2 ppts higher than a year  ago.  Also, job growth per month averaged 142K in the past three reported months, down from 179K per month in March-May and 233K per month in December-February and little better than 135K per month witnessed in June-August 2012, a performance that compelled officials to undertake the present quantitative easing arrangement.

The actual and expected paths to be taken by U.S. quantitative easing don’t seem to matter much for dollar relationships against the three so-called “hard currencies,” that is the euro, yen, and Swiss franc which are traditionally associated with low inflation and current account surpluses.  Each pair continues to fluctuate within fairly narrow confines, unlike the behavior of emerging market currencies and commodity-sensitive currencies.  The latter will encounter difficulty if, as I expect, the Fed reduces quantitative easing later this month but stand to benefit if such action is delayed. 

Sterling is a different case altogether and a bit of a surprise.  For a long time, Britain seemed to be the poster boy for why not to slash fiscal support when in a recession.  Austerity was poured on austerity, and the U.K. economy predictably seemed stuck in a downward spiral.  Lately, in contrast, U.K. data have been considerably better than forecast, convincing investors that the Bank of England will be tightening its policy much sooner than its verbal forward guidance implies.  Being almost 4% below its 2012 mean level against the euro, sterling seemingly has ample scope to outperform other currencies so long as the British economy keeps running in a higher growth gear.

With U.S. domestic and international policy priorities increasingly in other directions, China’s leadership has progressively slowed the rate of yuan appreciation against the dollar.  China’s currency rose 1.9% in the final trimester of 2012, 1.1% in the first trimester of 2013, and 0.7% in the second trimester of 2013.  Russian President Putin’s threat of more support for Assad if Obama decides to strike Syria militarily is a throwback to the Cold War, when an enemy of one superpower automatically became a friend of the others.  For that matter, the current situation bears some resemblance to the alliances that made World War 1 unavoidable.  The “war to end all wars” was anything but.  Looking ahead, intensifying hostilities in the Middle East will lift oil prices, and thereby subject those emerging market currencies that have depreciated to further selling pressure.  How the dollar in general gets affected is much less clear.

Copyright 2013, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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