After months of speculation, the Federal Reserve has finally decided to begin tapering its $US85 billion dollar asset purchasing program. But in doing that, it has also adjusted its forward guidance, acknowledging that short-term interest rates will remain around zero per cent for longer than previously communicated.
There was considerable uncertainty surrounding the outcome of the Federal Reserve’s board meeting, with even the most ardent Fed watchers completely in the dark regarding whether the Fed would taper or not.
But taper it did – and perhaps by a little more than some expected. Starting in January, the Fed will purchase $US75 billion – rather than $US85 billion – of assets on a monthly basis. This will comprise $US35 billion (previously $US40 billion) of agency mortgage-backed securities and $US40 billion (previously $US45 billion) of longer-term US Treasury securities.
Obviously, the Fed’s balance sheet continues to rise at a rapid pace. But the decision sends a strong message to markets: the US recovery is on track and expected to be sustainable. Most of the new economic data since the Fed surprised markets by not tapering at the September meeting has been positive.
There has been a distinct improvement in the labour market, with non-farm payrolls rising at 200,000 per month and the unemployment rate declining to 7.0 per cent. But it would be a mistake to characterise the labour market as strong. That would be far from the truth, and the Fed has acknowledged that by adjusting its ‘forward guidance’.
Previously, the Fed said that it would consider raising short-term interest rates once the unemployment rate hit 6.5 per cent, subject to inflation expectations remaining well-anchored. In a subtle change, the Fed now believes that it will be appropriate to maintain current short-term rates until well after the unemployment rate dips below 6.5 per cent, particularly if projected inflation remains below the Fed’s 2 per cent goal.
The Fed declined to put a new threshold in place, although I suspect the new threshold will be around 6 per cent for the unemployment rate and that will be communicated at a later stage. This view is consistent with the Fed’s forecasts, with two-thirds of Fed participants believing that the Fed will begin raising rates in 2015. By that point, the Fed expects the unemployment rate to decline to between 5.8 and 6.1 per cent.
A lot will depend on what causes the improvement in the labour market: will it be driven by job creation or an ageing population and disgruntled workers reducing the participation rate? Probably a bit of both, and that will complicate matters.
In setting previous thresholds, I believe that the Fed has been caught out by the pace of decline in the participation rate, which has allowed the unemployment rate to reach its thresholds much faster than anticipated. In light of that, it is probably wise not to propose a new threshold just yet.
Bernanke reiterated that the next move for monetary policy – short-term interest rates or asset purchases – remains data dependent. But he said that if the labour market continues to expand at a similar pace throughout 2014 and inflation picks up towards the 2 per cent annual target, the tapering may finish towards the end of 2014.
That is certainly good news for the Australian economy, but as we know the Fed does not always stick to the goals it communicates. Hopefully the taper will continue throughout 2014, but it is far from a certainty.
Nevertheless, it is hard not to become more optimistic regarding the Australian economy in light of today’s developments. The Reserve Bank has been adamant that the dollar must go lower to facilitate an orderly restructure of Australia’s growth drivers. Exports are set to be a key driver of economic growth in 2014 and a lower dollar will help many of our sectors become a little more competitive against foreign competition. The Fed’s taper and expectations that it will continue over the year ahead will only help matters.
The US economy still faces a range of challenges and is not out of the woods yet. But most signs suggest that the recovery is in better shape now than it was just a few months ago. Labour market conditions have improved, industrial production and capacity utilisation are on the rise, and with the recent budget agreement it appears that government spending may stop providing a drag on the rest of the economy.
I expect that most of the asset purchasing program will be wound down during 2014, but it won’t be an orderly process. There is still considerable uncertainty and we still don’t know the extent of the market fall-out from unwinding these asset purchases. That could delay the tapering process. It is safe to assume that there will be some disruption in financial markets and among emerging economies, but for Australia today’s announcement appears largely positive.