- We expect Fed officials to announce the first slowing of QE at this week’s FOMC meeting
- The main risk to our expectations is the still-low level of core inflation
- We also expect the FOMC to pair any slowing of QE with qualitative changes to its forward guidance
In the press conference after the September FOMC meeting, Fed Chairman Bernanke offered three reasons for why the committee chose not to slow the pace of its bond purchases: (1) insufficient confirmation of the baseline forecast (i.e. weak data), (2) downside risks from the tightening of financial conditions over the summer and (3) uncertainty around the impact of upcoming fiscal negotiations. We believe Fed officials will have enough confidence on all three points to announce the first slowing of quantitative easing (QE) at this week’s meeting—although we would emphasize that we see this as a close call.
First, incoming data continue to improve. Nonfarm payroll growth has picked up to a three-month average growth rate of about 200,000, and the unemployment rate has declined to 7.0%—down from 8.1% at the time the program was announced. With the improvement in retail sales in November, economists estimate that gross domestic product (GDP) growth in the second half of 2013 has accelerated to 2.5% or higher—up from 1.8% in the first half of the year. Our own U.S. activity indicator has increased at an average rate of 3% over the last three months. In a nutshell, the incoming data show compelling evidence of a broad-based acceleration in U.S. activity.
Second, U.S. financial conditions look less worrisome than in September. Although interest rates have remained high, stock prices have increased further, credit spreads have narrowed, and the dollar has weakened against most developed market currencies.
Third, fiscal uncertainty has come down meaningfully. Although the budget battles in October proved very noisy, congressional negotiators ultimately found enough common ground to reopen the government and extend the debt ceiling temporarily. The recent bipartisan agreement to adjust federal spending limits for 2014 and 2015 should ease fiscal restraint next year, and should pave the way for smoother fiscal negotiations in coming months.
The main risk to our expectations is the still-low level of core inflation. At the September FOMC meeting press conference, Chairman Bernanke said that the decision to slow the pace of QE depended on “the receipt of evidence supporting the Committee’s expectation that gains in the labor market will be sustained and that inflation is moving back towards its 2 percent objective over time” (our emphasis). Since that time the incoming inflation data have offered a mixed picture. On the one hand, the six-month annualized inflation rate in the core personal consumption expenditure (PCE) price index picked up to 1.3% from a low of 0.9% in May. On the other hand, year-over-year inflation slipped lower, falling to just 1.1% in October.
Nevertheless, we think most FOMC members will recognize that inflation is a lagging indicator, and that an improvement in the labor market will ultimately pull inflation back up too. However, look for concerns about low inflation to figure prominently in the post-meeting statement and press conference.
We expect the FOMC to pair any slowing of the pace of QE with qualitative changes to its forward guidance. Many observers expect the FOMC to make structural changes to its threshold-based policy rule—for instance, by lowering the unemployment threshold to 6.0% from 6.5% currently. While the idea has its merits, public comments from Fed officials suggest they have reservations about this approach. Instead, we anticipate that the post-meeting statement will make qualitative changes to the forward guidance, emphasizing that the funds rate may remain low even long after the unemployment rate falls to 6.5%.