This past week the U.S. was graced with some surprisingly strong economic data.
GDP for Q3 solidly beat expectations, and Non-Farm Payrolls for October were well-ahead of the expected pace, even with the government shutdown.
Those strong numbers likely raise the odds that the Federal Reserve will begin the so-called “taper” in December, rather than in, say, March of next year. The “taper” refers to the action of slowing down the pace of the monthly bond purchases that are conducted through QE.
But while the Fed is looking to slow the pace of QE, there’s growing talk that it will find new ways to stimulate the economy using monetary policy. This week, Goldman’s Jan Hatzius argued that in addition to tapering, the Fed will reduce the threshold level of unemployment at which it would consider tightening interest rates. Currently, the Fed says it won’t think about tightening rates until unemployment falls to 6.5%. Hatzius believes — based on two papers that have been published by Fed economists — that the Fed will lower this level to 6.0%, which constitutes a form of easing inasmuch as it signals to the market that ultra-low rates will remain ultra-low for even longer than is being signaled now. This, theoretically, has the effect of lowering long-term interest rates and providing stimulus that way.
So, on one hand, the Fed might engage in some tightening (slowing the pace of QE), while with the other hand do more loosening (reducing the threshold at which it would consider raising interest rates).
So what gives?
There were two fantastic blog posts this week that explain what’s going on.
The first was from Kevin Ferry at The Contrarian Corner who explained that QE is essentially an attempt to stimulate the economy by increasing the quantity of money out there, whereas in the past the Fed tried guiding the economy by directly guiding interest rates. Ending QE but doing more with forward guidance is essentially a handoff and a return to the old days, in that the Fed is going to try guiding interest rates again. (in this case very long ones).
Economist Tim Duy wrote something very similar later in the week:
Bottom Line: Policymakers would like to normalize policy by moving away from asset purchases to interest rates. Emphasising forward guidance is part of that process. Incoming research suggests not only that threshold based forward guidance is effective, but has room to be even more effective. That should be a comfort to policymakers who worry that ending asset purchases will excessively tighten financial conditions; they have a tool to change the mix of policy while leaving the level of accommodation unchanged. Whether they use it or not is another question. There has clearly been some discomfort among policymakers regarding changing the unemployment threshold. This suggests it would not necessarily be an immediate replacement for ending asset purchases. That said, it is difficult to see how the current threshold is meaningful at all if the Fed is still purchasing assets when the threshold is breached. Indeed, the current low level of unemployment relative to the threshold, combined with clear indications that the Fed has no intention of raising rates anytime soon, argues by itself that a change in the thresholds is a likely scenario in the months ahead.
With the strong data, the “taper” chatter is going to heat up. But it’s important to keep an eye on what’s going on. There’s a good chance that what the Fed will do is not desire to tighten, but just alter its strategy towards one of guiding interest rates again, as it did in pre-crisis days.