When we look back on the FOMC meeting on June 19 2013, it will probably be seen as the moment when the Fed signalled that it was beginning the long and gradual exit from its programme of unconventional monetary easing. The reason for this was clear in the committee’s statement, which said that the downside risks to economic activity had diminished since last autumn, presumably because the US economy had navigated the fiscal tightening better than expected and the risks surrounding the euro had abated.
This was the smoking gun in the statement. With downside risks declining, the need for an emergency programme of monetary easing was no longer so compelling. The Fed has been the unequivocal friend of the markets for much of the time since 2009, and certainly ever since last September. That comfortable assumption no longer applies.
Fed chairman Ben Bernanke, however, went to great lengths to mitigate the hawkish overtones of this message in several respects. The asset purchase programme would be ended only when the US unemployment rate has fallen to 7 per cent, which the central bank expects to happen by mid-2014, he said. In the meantime, the pace of asset purchases could be increased as well as reduced, depending on the incoming economic data.
As expected, the chairman also emphasised as strongly as he possibly could that the date of the first rise in the federal funds rate would follow a long time after QE3 ends. The 6.5 per cent unemployment threshold required for this to occur was certainly not to be viewed as an automatic trigger, and there were hints that this figure could be reduced before too long. This is welcome, since 6.5 per cent has looked too high for quite a while.
The Fed has taken a calculated risk by starting the exit process before there has been any significant improvement in the labour market, only the expectation of one. Past experience suggests that the bond market might be very sensitive to the first signs that the central bank is losing its enthusiasm for further easing. In 1993-94, and to a lesser extent in 2003, bond yields rose sharply, and the equity market fell for a time, on the first indication that the Fed might be contemplating a change in direction. Since central banks tend to manoeuvre very slowly, somewhat like supertankers, this is a rational response, and it has already shown signs of taking hold this time.
The big risk is that bond yields will rise too far, before the improvement in the labour market has been given enough chance to gather momentum. When Bernanke commented in May that tapering could take place “in the next few meetings”, it seemed that the Fed might be reneging on its commitment that asset purchases would continue until there had been a substantial improvement in the outlook for the labour market, in the context of price stability. Many were ready to criticise the Fed for this, but tapering has now been made explicitly contingent on further, specified improvements in the labour market, which is a much better place to be.
It is likely that the Fed will still be criticised by some for threatening to take away the punch bowl while the labour market remains extremely slack. Last September, Bernanke said, in highly unusual language, that the employment situation represented “a grave concern” and added that:
The weak job market should concern every American. High unemployment imposes hardship on millions of people, and it entails a tremendous waste of human skills and talents.
The markets took this as a clear shift in the Fed’s policy reaction function, and many risk assets rallied very sharply. This regime change has recently been called into question, but these doubts should be mitigated by the fact that the Fed has now said so clearly that a substantial improvement in the labour market has to take place before QE3 ends.
Recent data suggest that this might take quite a while. It is true that the monthly increase in private non-farm payroll employment is now averaging about 199,000, compared with 129,000 last September. However, when Bernanke described the labour market as a grave concern, the unemployment rate was 7.8 per cent. Now it is only slightly lower, at 7.6 per cent. Furthermore, declines in the participation rate continue to explain most of the drop in unemployment, while the employment/population ratio, which is perhaps the best single measure of the state of the labour market, is still flatlining:
Other, less familiar, indicators of the health of the labour market also suggest that the pace of improvement is very slow indeed. The following complicated-looking graph (which is similar to this work by Dave Altig and others at the Atlanta Fed) illustrates the point. (See also this chartpack).
In the graph, the black circle represents the normal position of each indicator when the labour market is in a healthy state, while the origin represents the worst levels reached during the recession. The red line shows where the indicators were at the launch of QE3, and the blue line shows where they are today:
Two conclusions are immediately apparent. First, with the exception of job loss data, all of the other indicators remain a very long way from being consistent with a healthy labour market. Second, the changes since last September have not been very meaningful in any of the data series, except possibly non-farm payrolls, which of course capture much of the public attention.
If the Fed viewed the labour market as a major national problem late last year, it is not clear from the bulk of this information why it should have changed its minds since then. It seems from the new unemployment thresholds introduced on Wednesday that it basically agrees with this.
So the exit has started, and risks to all asset classes have risen as a result. But the Fed is working very hard to persuade the market that it really will be different this time, and the labour market data certainly suggest the process will be a long one. The response of the bond market shows that investors are aware that the supertanker is turning, but I suspect that the conditions required for a major bear market in bonds are not yet in place.