Orlando's Outlook: Status quo at the Fed
Bottom line Fed-watching investors who had eagerly circled this week on their calendars—in the hope of gleaning some pertinent insight into the Federal Reserve’s collective thought process regarding its tapering and tightening plans—were likely to be disappointed. On Wednesday, the Fed released the minutes from its Federal Open Market Committee (FOMC) meeting on July 30-31, and the central bank kicked off its annual monetary policy conference in Jackson Hole, Wyo., yesterday, with formal panels and presentations running today and tomorrow. The Fed minutes suggest to us that the timing, size and duration of the seemingly imminent tapering of Quantitative Easing (QE) remain data dependent, and the eventual tightening of the target federal funds rate is unlikely to commence before 2015.
Jackson Hole lacking star power For the first time in a quarter century, the chairman of the Federal Reserve has chosen not to attend the Jackson Hole conference. Chairman Ben Bernanke announced last April that he had a “personal scheduling conflict” that would prevent him from addressing the prestigious symposium started by the Kansas City Fed in 1978, which routinely draws top central bankers from around the world to discuss global economic issues. But the unmistakable message is that Bernanke would not be serving a third term as the Fed’s chairman when his current term expires at the end of January 2014.
Aside from Chairman Bernanke’s absence, there are no other Fed speakers on the agenda this year, thus depriving investors of potentially critical monetary-policy clues. It was at this seminar last year during his keynote speech that Chairman Bernanke hinted at his subsequent plans for “QE 3,” which he then launched in September.
Current Vice Chairman Janet Yellen, whom we believe is one of the favorites to replace Bernanke as chairman, is attending Jackson Hole, but she is simply chairing Saturday’s presentations and panels. She is not delivering a keynote speech herself. Dr. Stanley Fisher, the outgoing governor of the Bank of Israel whom we believe is a dark-horse candidate to replace Bernanke, is chairing today’s speeches and panels. Other bold-face attendees include today’s luncheon speaker, Christine Lagarde, managing director of the International Monetary Fund (IMF), and Haruhiko Kuroda, governor of the Bank of Japan (BOJ), who will share his thoughts on a panel tomorrow. But critics suggest that without any Fed speakers, this year’s Jackson Hole symposium will resemble an academic snooze-fest.
When might the Fed begin to taper? The Fed’s “QE3” bond-buying program, in which the central bank is purchasing $45 billion of Treasury and $40 billion in agency mortgage-backed securities each month to keep interest rates low, has helped to successfully spark a “Wealth Effect” in the equity and real estate markets, which has intentionally helped to offset the economic drag from Washington’s suboptimal fiscal policies. Real estate prices are up by more than 12% nationally over the past year through May, according to Case-Shiller, and the S&P 500 has risen by 17% over the past year. Because two-thirds of Americans own their own homes and more than half own stocks in their retirement- and college-savings plans, aggressive monetary policy has clearly helped to buoy the economy.
We believe Bernanke would like to personally commence the taper himself before he retires from the Fed, so we expect that the central bank could introduce a partial taper (perhaps $10 billion to $20 billion per month to start) at the two-day FOMC meetings on either Sept. 17-18 or on Dec. 17-18. These meetings are scheduled to have a press conference at their conclusion, which Chairman Bernanke prefers.
A key point, however, is that given decidedly sub-trend Gross Domestic Product (GDP) growth over the past three quarters—0.1% in the fourth quarter of last year, 1.1% in this year’s first quarter and 1.7% last quarter—we fully expect the Fed to wait for a stronger economic uptick before pulling the trigger to commence the taper. So we firmly believe that the taper will ultimately be a data-dependent decision, and that the Fed will only begin to taper if the economy is demonstrating sustainable strength, a positive which the equity market should enthusiastically embrace eventually after it recovers from its inevitable negative knee-jerk reaction. Once started, the Fed could gradually dial the monthly taper down from $85 billion to zero over perhaps a six- to nine-month period as the labor market continues to improve. If the unemployment rate (U-3) continues to grind lower from 7.4% currently to 7% or lower over the next few quarters, then the Fed may decide to wrap QE3 up by mid-2014.
Fed funds rate on hold In a completely separate decision, we do not expect the Fed to begin to raise the target federal funds rate, currently set in a range of zero to 25 basis points, before 2015 at the earliest. The Fed has established two triggers or thresholds for this decision:
- Core inflation at 2.5% or higher The Fed would like to see the core year-over-year Personal Consumption Expenditures (PCE) index, its preferred measure of inflation, at 2.5% or higher, which is roughly double the current 1.2% rate through June.
- Unemployment (U-3) at 6.5% or lower With the U-3 at 7.4% (a new five-year cycle low) in July and grinding lower, we could trigger this threshold at some point over the next year or so. But Fed officials have become increasingly concerned about the quality of the improvement in the labor market. The labor-force participation rate was at 63.4% in July, which is marginally above the 34-year cycle low of 63.3% set in April, and the labor impairment rate (U-6)—also known as the “total” rate of unemployment because it more broadly includes discouraged workers and the underemployed—was at 14% in July. So the Fed may choose to ignore a 6.5% reading on unemployment, or perhaps adjust the trigger lower—to perhaps 6% or 5.5%—in coming quarters.