Looking Beyond the Taper

Sometime soon the Fed will reduce its current level of asset purchases. Let’s look quickly at why the Fed will be taking that action and then move beyond that day to think about how monetary policy might evolve over 2014.

Since September 2012 the Fed has been buying $85 billion per month in treasury and agency securities. The fed and most economists agree that the various large scale asset purchases have reduced interest rates not only for the federal government but also for consumers (in the form of mortgages and other forms of borrowing ) and corporations (via corporate bond yields and higher stock market prices). These purchases may have negative effects at some point. Those negative effects include the distributional effects of lower interest rates on savers, encouraging the reach for yield by private investors, the potential to disrupt the smooth functioning of the bond market and both the risk and the perception of risk to the fed’s balance sheet. The FOMC seems to be coming around to the idea that soon it will be time to remove this particular extraordinary measure it has taken to support the economy.

Last summer the Fed broached the possibility of trailing off its current bond buying program, an event known as The Taper and it struck fear into Fixed Income desks everywhere. The US 10 year bond yield rose 100 basis points in two months. Will we see another Taper Tantrum this winter? Our guess is no, based on the logic 1) the bond market is already significantly higher than it was in May 2013. 2) the second time is easier for the market (see this year’s debt ceiling versus 2011) and 3) that the markets have a better understanding of the fed’s process and plans. Instead of a Taper Tantrum we foresee a Taper Torpor. However, that we called it “a guess” should emphasize the great deal of uncertainty associated with the prediction of a relatively benign reaction.

After the taper begins and has been digested by the market, what will the Fed do next? The answer depends on the evolution of the economy. In its last several statements the Fed has indicated that it intends to keep short term interest rates “exceptionally low” at least as long as unemployment is above 6.5% and it is comfortable with inflation and inflation expectations. We expect to see this guidance become more dovish as the Fed tapers its asset purchase plan.

2014’s Message: Lower for Longer

The Fed’s typical pattern before the financial crisis would suggest a return to a normal rate in calendar 2014. Barring a large surprise to the upside, US employment and output levels are likely to be well below potential for all of next year. In these circumstances current understanding of economic theory is that the Fed should simply promise not to raise rates. Some Fed studies (brave readers may want to tackle the difficult but rewarding paper by William English) seem to show that the Fed finds it hard to make such a promise credible. The inability for the markets to believe or understand Fed intentions has led to the current guidance based on the outcome of macro variables. The Fed is broadly interested in the labor market and has mainly been talking in terms of the unemployment rate. While some commentators believe that the natural unemployment rate will be higher in the future, many inside the Fed (see the paper by David Wilcox) seem to think that the economy still possesses a great deal of untapped potential, be it employed workers, workers who have left the labor market or excess industrial capacity. Crucially, this untapped potential is seen by its advocates as being able to be drawn back into the active economy, not lost forever in the excesses of the credit and housing bubbles.

We expect the Fed to reiterate its intention not to raise rates until the labor market has improved but also to lower its unemployment threshold to a rate of 6% or even lower. While our expectation is that the fed will be patient, they may be reluctant to change the threshold simply because they have had difficulty explaining their monetary policy to the market. In addition, the FOMC has been at pains to emphasize that the 6.5% level is a level at which action is possible, not a trigger where action is necessary. Instead of changing its threshold the Fed may well simply refrain from acting, though this risks additional communications problems. Regardless of whether they explicitly or implicitly change the amount of labor market improvement the Fed is looking for, it will likely take the economy a bit of time to get there. Whether you ask the FOMC members or survey professional forecasters, it will likely take us until 2016 before the unemployment rate gets below that threshold. Of course the economy could surprise on the upside, but be very clear if you think short term rates will rise any time soon you are betting against the Fed and the market consensus.

In addition to its goal of an improving labor market, the Fed has also said that it may revisit its commitment depending on inflation. However, it is important to note that it is not inflation prints per se that will alarm the Fed, but rather the FOMC’s projections for inflation over the next two years and longer run inflation expectations. So the fed has said it will look though price shocks it believes to be temporary. Furthermore, the message we read into this is that the Fed will be biased toward seeing inflation increases as temporary. In short we think the fed is coming as close as good central bankers are allowed to come to saying inflation is OK for the next few years.

Some thoughts on rates for 2014

Where do rates stabilize next year? That is the hardest question. History is only of modest help as we have not been in this situation before. Next year’s nominal growth should be someplace between 3.5% and 5%. Looking at the chart below we see that these are levels of nominal growth that, since 1950, the US only saw in recessions. This alone suggests that, despite recent improvement, long term bond rates should stay low compared to what might be considered normal based on the last ten or twenty years. Market expectations of “lower for longer” short term interest rates, stable inflation expectations, further improvement in the budget deficit and substantial economic slack are all pointing to yields staying relatively low. In addition, the Fed will, at first, maintain a steady amount of bonds on its balance sheet, also supportive for bond prices. That being said, the market may over-react to the reduction in the amount of bond purchases. Also the market will eventually anticipate tightening, perhaps by a year or more.

graph

Assuming that the paths for the Fed and the US economy unfold as expected, we expect to see long term rates only modestly higher than current levels (say 3-3.5%) over the course of 2014, with the main risks being yields being higher than anticipated. We think it would take a substantial deterioration in the economy to lower rates back toward the 2% level we saw at the beginning of the 2013, say payroll growth averaging lower than 50,000 over at least two months. On the other hand, is it possible for investors to demand higher returns to hold treasuries, driving long term rates significantly higher than we anticipate? Of course, though it is hard right now to see a trigger for a buyers strike In the context of a winding down of extraordinary monetary policy actions and slow growth, especially in the absence of a substitute risk-free asset. Hard to imagine, but not impossible. As always the market will doubtless bring surprises in the coming months.

-John Eckstein