- The outlook for quantitative easing remains difficult to gauge.
- We see decent odds that tapering begins in the not-too-distant future—primarily because we expect firm growth.
- If Fed officials were to revise their views on the costs and/or efficacy of QE, they may attempt to lean harder on the forward guidance tool.
Last week the debate about quantitative easing (QE) was quickly overshadowed by the fiscal circus in Washington. The economic impact of the shutdown cannot be known for certain, but estimates from economists suggest a drag of about 0.25%-0.50% on annualized fourth quarter gross domestic product (GDP) for every two weeks the federal government remains closed. Needless to say, a debt ceiling crisis could have much more worrisome impacts on the economy if it leads to a missed payment on the government’s debt. If the standoff continues beyond this week it will likely increasingly cloud the U.S. economic outlook.
Yet even setting aside these tail risks, the outlook for QE remains difficult to gauge. Fed officials surprised markets with their decision to maintain the pace of QE at $85 billion per month at the September FOMC meeting, and their subsequent public comments did not provide much clarity (see our earlier take here). We will need to wait for more communication to get a clearer picture on the direction for policy.
For the time being we are thinking about the QE outlook as a simple decision tree as shown in the diagram (for simplicity we ignore a recession scenario). If incoming data appear strong over the next few months, we think the outlook for QE would be straightforward: the Fed would begin to taper at the December or January FOMC meeting. This would certainly be the convenient scenario from the standpoint of the central bank’s credibility.
For illustrative purposes only.
More problematic would be an environment of lackluster growth, especially with a falling unemployment rate—in other words, more of the same. Here we are not sure how Fed officials might respond. One option would simply be to continue QE for significantly longer than most FOMC members initially planned—and much longer than markets anticipated when Federal Reserve Chairman Bernanke “corrected” those views in May and June. This would be consistent with the growth-based criteria that Federal Reserve Bank of New York President Dudley and others seemed to advocate for in recent speeches.
Continuing QE at full speed deep into 2014 could create new challenges, however. First, it would reintroduce questions about the costs and risks of the program such as the eventual impact on future remittances to the Treasury and distortions to the functioning of fixed income markets. Second, if growth fails to accelerate, policymakers would presumably need to revise their views on the efficacy of the program—why press on if there are no apparent effects? These considerations could lead to tapering even if economic growth remains historically moderate.
Putting it together, we see decent odds that tapering begins in the not-too-distant future—primarily because we expect firm growth, but also because we see some chance that Fed officials would consider winding down the program because of concerns about its costs and/or efficacy. However, the September decision has added a fat tail to the distribution of possible outcomes: we cannot rule out QE continuing at its current speed far longer than we envisioned just a few weeks ago. Complicating matters further, we do not know what level of growth would be “good enough” to warrant tapering nor which indicators Fed officials will be primarily focusing on (the indicators and thresholds they stressed earlier this year seemed to imply tapering in September).
Last month’s surprise may have also increased the odds that the committee will rework its forward guidance in some way (though this will depend importantly on the identity of the next Fed Chair). Chairman Bernanke appeared to back away from the threshold-based guidance given at the December 2012 and June 2013 meetings, but he was noncommittal about what changes the committee could make in the future. Plus, if Fed officials were to revise their views on the costs and/or efficacy of QE, they may attempt to lean harder on the forward guidance tool. Indeed, this was a widely held view about the committee’s intentions before the September FOMC meeting. We will be looking for clues on both QE and forward guidance in the minutes from that meeting, which will be released later this week.