Divyang Shah, Senior IFR Strategist
The minutes of the April 30-May 1 FOMC meeting told us that “a number of participants expressed willingness to adjust the flow of purchases downwards as early as the June meeting”.
The commentary and volume of Fedspeak since the meeting early this month have confirmed that there are loud voices within the Fed who want tapering to begin as early as the next meeting in June.
But just because there is a large and vocal group in favour of tapering QE does not mean that the more powerful doves will comply. Those in the “early tapering of QE” camp have not been ignored but for the doves to be satisfied there are several conditions that have to be met. At the top of the list here is the need to see an improvement in the labour market.
On this score Bernanke noted that the job market remains weak despite some recent improvement. The focus on:
1) a high unemployment rate
2) high levels of long-term unemployment
3) a falling participation rate and
4) high level of part-time workers who want a full time job suggests it will take more than the next 1-2 jobs reports to change this picture.
Thus, the 3-4 months of forward guidance provided by NY Fed’s Dudley seems to more appropriately capture the time frame aspect to the tapering QE.
But in addition to the labour market we also have the inflation aspect to consider. While the contrast between PCE and CPI suggests caution in reading the Fed’s favoured measure of inflation, this is still an environment of “incipient deflationary pressures”.
Maintaining accommodative policy is thus also supported by the (dis)inflation backdrop. Fed’s Bullard (a voter) has highlighted a need to see inflation heading closer to target before tapering QE.
Maintaining current QE at its US$85bn pace per month is the best course of action based on the Fed’s dual mandate and it’s up to incoming data to change this script. But there are two additional factors that the Fed will and cannot ignore;
1) they won’t be swayed by financial stability concerns to which the Fed will rely more on a targeted regulatory approach and
2) they can’t ignore the fiscal drag.
On the latter Bernanke went out of his way to suggest “less restraint in the very near term”.
If the labour market continues to improve and inflation moves back closer to target the Fed could taper QE before year-end. It seems more likely that the current pace of QE will be maintained this year with tapering likely to take effect early next year.
