- More signs that U.S. growth is accelerating; with 7% unemployment rate, look for qualitative communication changes at next FOMC meeting.
- Higher odds of December taper but we still think January is more likely (with possible hint in December press conference).
- We wonder whether front-end rates can remain anchored as growth picks up.
The November employment report brought more positive news on U.S. activity, with a healthy gain in nonfarm payrolls of 203k. The three-month moving average continued to hover around 200k (193k this month), and the payroll diffusion indexes pointed to a broadening of gains. We were also encouraged to see a further acceleration in construction and manufacturing employment. It bears mentioning that even the large rebound in household employment leaves the three-month average gain at just +72k. The participation rate also failed to recover all of last month’s large decline, suggesting that some of the weakness reflected more than the government shutdown. But on the whole the employment report continues the recent streak of better than expected economic news.
Taking all the latest data into account, we now see a convincing rebound from the government shutdown and a good amount of evidence of broad-based acceleration. The chart below shows our U.S. activity indicator, which now reports a three-month average growth rate of 3.0% (October was depressed by shutdown and November benefitted from the bounce back).
U.S. growth indicator, % annualized
Broadly speaking, improving activity data should bring forward the timing of tapering and probably motivates some reworking of the Fed’s communication framework. There remains a great deal of uncertainty about the details, however.
Given the decline in the unemployment rate to the symbolically important level of 7.0%—the original guidepost for the end date of QE—we now think communication changes of some kind are likely at the December meeting. Many observers continue to believe this will include mechanical changes to the threshold rule—a lower unemployment threshold and/or a new inflation floor. We continue to see both of these changes as unlikely.
On the lower unemployment threshold, minutes from the October FOMC meeting said that only “a couple” participants favored this approach, and subsequent public comments by Fed officials have focused communication for the “post-6.5-percent world” (Williams, Dec 3). We would not rule this option out entirely, but a lower threshold does not seem to be policymakers’ base case. Similarly, the minutes said only “a few” participants liked the inflation floor idea, and others expressed hesitations about modest benefits and communication challenges. While interesting, the Cleveland Fed paper on this topic published this week has no bearing on our views about the odds of such a change.
Instead, look for qualitative changes in the forward guidance, focused on what happens after the unemployment rate reaches 6.5%. We think this could include two main aspects: (1) more (qualitative) information about the conditions for an eventual rate hike and (2) more details about the economic rationale for the slow pace of hiking in the Fed’s Summary of Economic Projections (SEP). The former could be a sentence in the statement like: “In deciding when to raise rates—which may come a considerable time after 6.5% unemployment—the committee will consider a broad set of job market indicators, including consumer price inflation, wage growth and measures of underemployment.”
We expect that communicating the rationale for the slow pace of hiking in the SEP will prove challenging. So far Bernanke has talked about “headwinds” and a slow recovery in the neutral funds rate. Look for more of this in December—possibly in the statement itself.
The QE decision looks like a close call, but on balance we think tapering begins in January rather than December. On the one hand, there are strong tactical arguments for starting in December. First, it keeps intact Bernanke’s June guidance that tapering would begin “later this year” if “the incoming data were broadly consistent” with the Fed’s forecast. That forecast included second half GDP growth of about 2.5%, a Q4 unemployment rate of 7.2-7.3%, and Q4 core PCE inflation of 1.2-1.3%. Today’s dataset certainly looks “broadly consistent” with this picture. Second, tapering in December avoids the risk that a soft patch in the data—even if just noise—delays tapering deep into 2014.
On the other hand, Fed officials have set a high rhetorical bar for the conditions needed to begin slowing QE. Before the September FOMC meeting the Fed’s QE guidance stressed “cumulative progress” in the labor market—the level of the unemployment rate and total job gains. After the meeting policymakers added the condition that tapering required “convincing evidence that progress will continue”. Because we doubt officials are worried about a recession, we took this communication to mean that tapering could only occur in the context of “fast growth”. With Q4 GDP growth tracking below 2%, we suspect officials will still not see enough evidence to begin the process of winding down the program.
From a market perspective the precise tapering details may be beside the point. Long-dated forwards have priced in tapering, and the curve has started to flatten in sell-offs (see charts below). Rates investors seem to be focused less on tapering and more on growth. To us the big question is: will forward guidance become a victim of its own success? That is, will front-end rates remain well-anchored even as growth finally picks up? We suspect that the current equilibrium of accelerating growth and anchored front-end rates will not be sustained for long.
One-year forward rate curve, %
Source: Columbia Management
Change in one-year forward rate curve this week, basis points
Source: Columbia Management