Ben Bernanke is likely to signal that the U.S. Federal Reserve is close to tapering down its $85-billion (U.S.) a month in asset purchases when he holds a press conference on Wednesday, but balance that by saying subsequent moves depend on what happens to the economy.
The Fed chairman has a double communications problem. Markets seem reluctant to acknowledge the improvement that is leading the Fed towards a taper of QE3. But they also appear to be assuming, incorrectly, that any taper means the Fed has become less willing to support the economy’s recovery.
Mr. Bernanke is likely to push against both mis-perceptions, combining an upbeat message on how the strength of the economy will soon justify a taper, with a signal that further tapering depends on further improvement in the economy and in no way brings forward an interest rate rise.
When it started QE3 last September, the Fed said it would keep buying assets until there was a “substantial improvement” in the outlook for the labour market. Since then, two main developments are driving the Fed’s move towards a taper now.
First, the main indicators of the labour market have improved. The Fed’s projection for unemployment at the end of 2013 is down from 7.75 per cent to 7.4 per cent and falling. Average payrolls growth in the past six months has been 194,000 compared with 130,000 in the six months leading up to QE3.
Monthly payrolls have become less volatile. The economy is weathering tax rises and federal spending cuts. Although markets have been slow to acknowledge it, all this looks like a substantial improvement.
There is still a dark side to the labour market – measures of dynamism such as rates of hiring, quitting jobs and working part time because a full-time job is not available – have barely improved. But that is offset somewhat by the second development.
When the Fed began QE3 last autumn it was working on the assumption that a lot of people who had given up looking for jobs would return once the economy improved. That may still happen – there were some signs of it in the last jobs report – but a steady flow of Fed research suggests participation will stabilize rather than bounce back.
As a result, there is a mood inside the Fed that payrolls growth of close to 200,000 a month is quite a lot better than it looks, and may be all that is needed to keep the unemployment rate coming down. In other words, some Fed officials’ definition of “substantial improvement” has got a bit less optimistic over time.
To add still more accommodation even as the labour market gets better – which is how the Fed regards adding $85-billion (U.S.) a month to its stock of assets – is like the fire brigade pumping faster even as the fire goes out. At some point the extra water does more damage than the remaining flames. But that does not mean the Fed is going to turn off the water and let the building catch fire again.
A couple of complications exist. One is unexpectedly low inflation. Most Fed officials are sanguine about the drop in their favoured measure of core inflation to 1.1 per cent. Expectations of future inflation are holding up and a similar slide in 2010 did not end in deflation despite a weaker economy. So far, it is a minor factor in the Fed’s calculations, although it will weigh more heavily if expectations move or inflation defies forecasts and stays low.
The other complication is the rise in bond yields, triggered by the confused market response to a likely Fed taper, which has in itself tightened financial conditions. Market movements are unlikely to delay a Fed taper – but they are likely to make it cautious until it has got its message across.