Is Fed ready to begin the great taper? Markets say yes

Is the Federal Reserve ready to put the Great Recession behind it? Is the US economy prepared for it?

The markets think so, as the Fed’s policy board prepares to meet on Tuesday and Wednesday to decide a momentous step: whether they begin cutting back its stimulus for the economy, $85 billion a month pumped in via bond purchases to fuel the engine.

Four months after Fed Chairman Ben Bernanke first suggested that the central bank could start to taper its stimulus program, called quantitative easing (QE), sometime this year, most expectations are that the Federal Open Market Committee (FOMC) will take the step.

And with Bernanke expected to step down at the end of January, many believe he needs to set the policy path now, rather than having it delayed for months until his successor settles into the job.

The prospect of less easy money from the Fed has already taken US stocks down from their all-time highs, and sent market interest rates climbing sharply. The yield on the benchmark 10-year Treasury bond has nearly doubled in four months, from 1.6 percent to 3.0 percent.

The anticipation has also wreaked havoc in emerging markets.

A pullout of foreign capital, driven by falling returns, turned into a flood outward when US bond yields rose. That sent authorities in countries like Indonesia, India and Turkey into a panic over their plummeting currencies.

And although that has drawn warnings to the Fed from around the world to not act too precipitously, analysts say the only question surrounding the taper is when, and how fast.

In his effort to remove any obscurity from Fed communications — to make sure that everyone understands clearly what FOMC members are thinking — Bernanke has set the course firmly to taper.

On May 22 he told a congressional hearing that the Fed could begin cutting the QE bond purchases “in the next few meetings” of the FOMC, while adding the condition, “If we see continued improvement, and we have confidence that that is going to be sustained.”

Three weeks later he was more precise, saying the cutback could start “later this year” and be completely wound up by mid-2014.

But by July he was more cautious, voicing a worry over how government spending cuts might slow the economy through the rest of the year.

The minutes to the end-July FOMC meeting echoed that shift. Several members wanted to go ahead with the taper, while others counseled “the importance of being patient”.

Economic data has backed both views. At the end of August the official estimate of US economic growth in the second quarter was raised to a solid 2.5 percent.

The August jobs report put the unemployment rate at 7.3 percent, compared with 8.1 percent a year earlier, and data on corporate and government layoffs has steadily improved.

But the report also showed a significant slowdown in new job generation for the June-August period. Gains in the unemployment rate were largely from the number of people dropping out of the jobs market altogether.

In addition, the rise in interest rates appears to have slowed the rebound of the property sector, and fresh retail sales data Friday suggested that, with the exception of buying new cars, US consumers were being very cautious about opening their wallets.

“Businesses aren’t laying off workers — the layoff rate is at a record low and initial unemployment insurance claims are trending down — but they aren’t hiring many, either,” said Mark Zandi, chief economist at Moody’s Analytics.

But as Zandi points out, the economy continues to heal, and the Fed’s bond purchases — aimed at holding down long-term interest rates — have less impact as time passes.

Most analysts say there is not enough economic bad news for Bernanke to reverse course.

But the FOMC could cut its bond purchases by a small amount — $5 to $20 billion out of the $85 billion total — and then hold off on more cuts to see where the economy goes, analysts say.

Or it could put off the decision to one of the FOMC’s two remaining meetings this year.

“The Fed will likely hold off on tapering at next week’s meeting and move in December,” said economists at IHS Global Insight in a report Friday, taking a minority view.

“The jobs market is simply too uncertain and there are risks on the horizon from Syria and congressional fiscal fights.”