The Fed and Tapering -- Anybody's Guess

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The Fed and Tapering -- Anybody's Guess
Andrew Harrer/Bloomberg via Getty ImagesFederal Reserve Chairman Ben Bernanke.
By Dunstan Prial

Everyone seems to have a strong opinion on what the Federal Reserve will announce Wednesday following this week's two-day meeting of the policy-setting Federal Open Market Committee. But no one knows for sure.

The Fed has shown a knack for keeping the markets guessing.

Will they announce a reduction in their monthly $85-billion-a-month bond purchase program or won't they?

Peter Cardillo, chief market economist at Rockwell Global Capital, says they will.

"They'll announce tapering tomorrow and they'll upgrade their economic outlook. They'll indicate that finally the economy is beginning to run on all gears," Cardillo said Tuesday. "This would be a clear message that the Fed is not worried about the economy -- that the economy is doing well and doesn't need help anymore."

Cardillo said FOMC policymakers are likely concerned about a Fed balance sheet that is approaching $4 trillion as a result of the asset purchase programs known as quantitative easing begun five years ago in the wake of the 2008 financial crisis.

"It's getting really hefty," he said.

The timing is right, according to Cardillo, %VIRTUAL-article-sponsoredlinks%because the Fed has been telegraphing a reduction in its easy-money programs for months but has held off until the economy showed sustained momentum.

Conventional wisdom in the fall held that a sharp market selloff would follow a tapering announcement, as investors mourned the loss of easy money. But Cardillo believes that won't happen Wednesday because markets have already priced in tapering.

Besides, the tapering will be "limited" -- a reduction of $8 billion to $10 billion per month, he predicted, "to see how the markets handle it."

Not everyone agrees that tapering will commence later this month.

Despite the "strong logical case for phasing-out QE," David Kelly, chief global strategist at JPMorgan Funds, said the feeling among many Wall Street investors is that the Fed will wait another month before tapering.

Avoiding the 'Tough Decision'

"This Federal Reserve has proven itself to be among the most dovish in history," Kelly wrote in a note to clients. "Because of this, many investors continue to believe that they will avoid the tough decision for at least another meeting."

Kelly's "logical case" for scaling back QE sooner rather than later includes a reduction in the unemployment rate from 7.8 percent in September 2012, when the Fed initiated its latest round of bond purchases, to 7 percent in November as the economy added 2.3 million jobs in that 14-month period.

"While logically the decision to taper on Wednesday shouldn't be a close call, in practice it is. If the Fed does decide to reduce bond purchases, we might well see long-term rates rise, the dollar appreciate and stocks fall, although the latter reaction could be short-lived," Kelly said.

The Fed has made it clear that a healthy labor market is its top priority and its stimulus programs -- QE and near-zero interest rates -- were designed to spur lending to create demand for goods which will in turn generate jobs. How successful the programs have been remains an open question.

Kelly noted that [gross domestic product] growth has accelerated in 2013 and that last week's bi-partisan budget agreement in Congress, which eliminates some mandated budget cuts known as sequester and could preclude additional budget standoffs for a couple of years, add to the argument for immediate tapering.

Kelly said the Fed's criteria for tapering, established over the past year, seems to have been filled. "For the Central Bank to maintain its credibility, its words of the last year should mean something, and it should thus begin to reduce bond purchases now," he said.

The Fed has surprised markets in the past, notably in September when virtually everyone believed tapering would begin, but the Fed maintained easy money. Then Congressional bickering shut down parts of the government in early October and raised the threat of a U.S. default, and the September jobs report, released three weeks late because of the shutdown, was disappointing.

So it was no surprise when the Fed held off again after its October meeting. The two most recent labor reports for October and November have been strong -- more than 200,000 new jobs each month -- however, so tapering is squarely back on the table.

The Fed and Tapering -- Anybody's Guess
The gross domestic product measures the level of economic activity within a country. To figure the number, the Bureau of Economic Analysis combines the total consumption of goods and services by private individuals and businesses; the total investment in capital for producing goods and services; the total amount spent and consumed by federal, state, and local government entities; and total net exports. It's important, because it serves as the primary gauge of whether the economy is growing or not. Most economists define a recession as two or more consecutive quarters of shrinking GDP.
The CPI measures current price levels for the goods and services that Americans buy. The Bureau of Labor Statistics collects price data on a basket of different items, ranging from necessities like food, clothing and housing to more discretionary expenses like eating out and entertainment. The resulting figure is then compared to those of previous months to determine the inflation rate, which is used in a variety of ways, including cost-of-living increases for Social Security and other government benefits.
The unemployment rate measures the percentage of workers within the total labor force who don't have a job, but who have looked for work in the past four weeks, and who are available to work. Those temporarily laid off from their jobs are also included as unemployed. Yet as critical as the figure is as a measure of how many people are out of work and therefore suffering financial hardship from a lack of a paycheck, one key item to note about the unemployment rate is that the number does not reflect workers who have stopped looking for work entirely. It's therefore important to look beyond the headline numbers to see whether the overall workforce is growing or shrinking.
The trade deficit measures the difference between the value of a nation's imported and exported goods. When exports exceed imports, a country runs a trade surplus. But in the U.S., imports have exceeded exports consistently for decades. The figure is important as a measure of U.S. competitiveness in the global market, as well as the nation's dependence on foreign countries.
Each month, the Bureau of Economic Analysis measures changes in the total amount of income that the U.S. population earns, as well as the total amount they spend on goods and services. But there's a reason we've combined them on one slide: In addition to being useful statistics separately for gauging Americans' earning power and spending activity, looking at those numbers in combination gives you a sense of how much people are saving for their future.
Consumers play a vital role in powering the overall economy, and so measures of how confident they are about the economy's prospects are important in predicting its future health. The Conference Board does a survey asking consumers to give their assessment of both current and future economic conditions, with questions about business and employment conditions as well as expected future family income.
The health of the housing market is closely tied to the overall direction of the broader economy. The S&P/Case-Shiller Home Price Index, named for economists Karl Case and Robert Shiller, provides a way to measure home prices, allowing comparisons not just across time but also among different markets in cities and regions of the nation. The number is important not just to home builders and home buyers, but to the millions of people with jobs related to housing and construction.
Most economic data provides a backward-looking view of what has already happened to the economy. But the Conference Board's Leading Economic Index attempts to gauge the future. To do so, the index looks at data on employment, manufacturing, home construction, consumer sentiment, and the stock and bond markets to put together a complete picture of expected economic conditions ahead.
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