The Fed ploughs on through the storm

Despite softer recent data, don’t expect the Federal Reserve to change course anytime soon. The Fed remains determined to continue to reduce its asset purchases when it next meets in March.

Appearing before the US Senate Banking Committee, Federal Reserve chair Janet Yellen reiterated that the taper of the Fed’s asset purchasing program is likely to continue but her comments suggest that the Fed is perhaps a little more concerned about the US economy than it was when she addressed US congress on February 11.

A lot has changed since Yellen appeared before congress. Retail sales fell by 0.4 per cent in January, while industrial production was down 0.3 per cent. Unusually cold and stormy weather continues to affect the economy, even delaying today’s testimony by two weeks.

The weather is certainly making things more difficult for the Fed, which is closely watching to determine what affect its tapering has had on the broader economy. Most new data since the tapering began on January 1 has been tainted in some way and that will continue to be the case over the next couple of months.

“Since my appearance before the House committee, a number of data releases have pointed to softer spending than many analysts had expected. Part of that softness may reflect adverse weather conditions but at this point it is difficult to discern how much,” said Yellen.

As such the Fed is understandably reluctant to jump to conclusions regarding the softer data it has been receiving. The Fed’s view would be that adverse weather is simply delaying economic activity and current weakness will be offset by stronger than normal activity when these weather effects rescind (Chill out: The US economy is fine, February 28). So far the evidence suggests that it has not downgraded its economic outlook. As a result, we should expect it to continue to taper when it next meets on March 18-19.

Yellen said that there has been vigorous debate within the Fed on how to adjust its forward guidance, which is at risk of becoming obsolete. The Fed currently has a threshold for the unemployment rate of 6.5 per cent, after which it has said it would consider raising interest rates.

But with the unemployment rate falling more quickly than the Fed had anticipated and reflecting falling participation as much as it has job creation, the Fed has no desire to raise interest rates any time soon. In order for forward guidance to provide any real guidance its unemployment rate threshold will need to be lowered, or perhaps broadened, to reflect the complex nature of monetary policy.

Realistically the Fed will not be tempted to raise rates until inflationary pressures begin to kick in. With the unemployment rate obviously much lower than it was a year ago, we should start seeing some price pressures in some industries but widespread inflationary pressures are likely some way off.

In a testimony that covered a range of topics, Yellen dismissed the view that the Fed’s asset purchases have created bubbles and financial excess. However, with the S&P500 flirting with a record high – sometimes for inexplicable reasons – and the general mayhem caused across emerging economies I find this a bit of a stretch. The real challenge for the Fed is timing the taper so that the rest of the economy has enough momentum to take over from the artificial financial conditions engineered by the Fed over the past few years.

Yellen and the Fed are sticking to their script, with it clear that they intend to keep tapering when they next meet in March. Current data – and the data they will receive over the next three weeks – is likely to be too tainted by adverse weather conditions to force their hand. Expect the Fed to cut its asset purchases by an additional $US10 billion at its next meeting.