Markets seem to be in for an extended period of volatility due to uncertainty about when the Fed will begin to taper QE3 . On one day the government releases an economic report signaling progress in our anemic economic recovery, followed a day or two later by another report suggesting the economy is stagnant or deteriorating.
Expectations about when the Fed will act rise and fall with the tide of these reports. We’re likely to be stuck in this pattern until the Fed announces a decision.
Volatility is inevitable considering the importance of QE3 to the course of both the U.S. and world economy, but it has been amplified by a misunderstanding of statements by Chairman Bernanke and other members of the Fed about how they’ll make decisions to taper. I’ll offer an interpretation in this post.
Why we’re confused about QE3
Confusion about Bernanke's June remarks about tapering QE3 caused significant market volatility this summer. Minutes of the FOMC (the Federal Open Market Committee) meeting in July, released last week, haven’t provided any greater clarity.
The other day I realized I, too, was confused, so I went to the transcript of Bernanke’s press conference on June 19 to sort it out. Lesson learned: when in doubt, look at the original source.
Bernanke’s statements about the Fed’s plans for tapering QE3 are quite clear but have been misunderstood for two reasons:
(1) QE3 is part of a complex and unprecedented monetary policy environment that is not well understood,
(2) as is appropriate in this environment, the course Bernanke laid out is rather subtle. Markets don’t do subtle well.
Alan Greenspan, for all his faults, understood that markets—and Congress, for that matter—don’t get subtlety, so he chose inscrutability when discussing Fed policy. He was widely admired for his indecipherable, oracular statements.
Bernanke, an optimist, chose transparency, and for his troubles he is criticized for both miscommunicating the Fed's intent and for vacillation. As far as QE3 is concerned, neither claim is warranted.
The Fed’s traditional means of increasing money supply is to buy government bonds to lower short-term interest rates throughout the economy. But this option is exhausted when interest rates approach 0.0 percent, as they have for several years now.
The Fed designed QE as a policy innovation to provide additional economic stimulus by lowering long-term rates through the purchase of bonds issued by private institutions. After more than three years of QE, the Fed is deep into uncharted waters.
Bernanke has described different “thresholds” which will guide the Fed’s decisions on when and how quickly to tighten traditional monetary policy (government bond-buying), on the one hand, and reduce QE, on the other. Financial reporters and analysts often confuse these two sets of metrics. Moreover, they've turned soft “thresholds” intended to guide Fed decisions into hard “targets” that will trigger its decisions.
What the Fed has in mind
The Fed’s monetary policy making is governed by a mandate: strike a balance between low inflation and full employment. The thresholds Bernanke reiterated in June are simply an expression of this mandate.
Members of the FOMC have agreed that they will end QE3 once unemployment falls from the current rate of 7.4 percent to around 7 percent with “solid” prospects for further job gains in future months. How quickly they taper will depend on how strong job growth is. Bernanke even foresaw the possibility the Fed might temporarily increase QE3 bond purchases if the economy flagged.
How will the FOMC determine that progress on the jobs front warrants tapering? The twelve voting members of the FOMC will each make subjective decisions shaped by their own policy inclinations, interpretations of the economic data, discussions with other FOMC members, etc.
In other words, the FOMC's decision is contingent on a wide range of factors that are inherently unpredictable. But one thing we do know is the decision will not be automatically triggered when unemployment hits 7 percent.
This might seem like a very murky basis for making such an important decision. Yes, but it’s murky for a good reason.
The FOMC reflects a wide range of opinion on monetary matters, from hawks intent on keeping inflation rates down to doves committed to increasing job creation. The decision-making formula Bernanke outlined is a Goldilocks solution: Just specific enough to provide some meaningful guidance but flexible enough that all FOMC members could sign on to it. But it does not facilitate divining the Fed’s course on QE3 by reading the tea leaves of every fragment of economic data dribbling out of the government.
For those with crystal balls
So, where does this leave those of us who insist on predicting the Fed's timing on tapering? First, a single monthly report is meaningless; the margin of error is too large. Reduce the noise by looking at trends in three-month rolling averages.
Of course, trends in unemployment and job creation are crucial, but these metrics look backward. The Fed will also be looking ahead for signs of sustained strength in the economy. Since the recovery has depended on housing and consumer spending, I think the key forward-looking metrics are new housing starts, home sales, and consumer sentiment. Most other data will be of secondary importance.
Factors beyond the data
But the Fed will likely look beyond U.S. economic reports in making its decisions, and there are looming clouds on the horizon that pose significant threats to the recovery.
Here at home, we face yet another round of congressional budget battles that will play out in September and October. Credible threats to shutdown the government or block an increase in the debt ceiling will reduce the prospect for Fed action on QE3. So would substantial cuts in the budget. QE has fought the headwinds of tax increases and spending cuts for years now. More budget cuts will undermine the recovery and reduce the likelihood of tapering this year,
But our economic recovery is not entirely determined by what happens here in the U.S.
Western intervention in Syria, more likely by the day, would reduce the prospect for tapering this fall. So would economic weakness in Europe, China and Japan, or in emerging markets, as we're seeing now with the currency crises in India, Brazil, Turkey, Indonesia, and elsewhere in Asia.
An overlooked feedback loop?
And finally, another factor the Fed must consider in deciding to taper: what will be the effect of tapering itself?
Tapering will increase interest rates; in fact, the prospect of tapering has already caused a spike in rates much larger than markets expected. Higher interest rates will reduce home buying, housing construction, and consumer spending, the pillars of the current recovery.
QE has been especially important in supporting economic recovery and expansion abroad. Tapering will pose new risks for many economies, especially in Europe and emerging markets. Why should we care about their fate? Exports. If they stop buying, jobs disappear here.
Finally, another big effect of QE3: QE is designed to keep long-term interest rates low, and the federal government has benefitted greatly from lower costs of financing the debt. Even at these extraordinarily low rates, interest on the debt now costs more than $225 billion a year, about 6 percent of the entire federal budget.
Tapering will increase those costs and therefore the deficit, bringing more political pressure in Congress to cut spending, raise taxes, or both. As I discussed earlier, spending cuts and higher taxes undermine economic growth and will delay the start or pace of tapering.
You can see what a dilemma the Fed faces in deciding what to do about QE3.
For all these reasons, I think the Fed is unlikely to begin tapering when it meets next month, and unless the economic data are clear and most of these geo-political clouds are dispelled, I doubt the Fed will act in December, either.
But I could be wrong. The Fed has a good track record of overestimating the strength of our anemic recovery. Maybe it will do it again.
What it means for gold
Of course, I always come back to gold. The prospect of tapering has depressed gold prices all year. If tapering looks less likely, gold will rebound. Also, gold thrives in periods of economic and political uncertainty in the world…pretty much what I've described in this post.