FOMC preview: QE tapering? Not yet
Bottom line: We expect that Federal Reserve chairman Ben Bernanke will use tomorrow's press conference to clarify that while there has been some improvement in the data, it has not been substantial enough to begin tapering quantitative easing (QE) yet. Updated economic projections are likely to include downward revisions to growth and inflation for 2013.
Details: The two-day Federal Open Market Committee (FOMC) meeting commences today and speculation has been rife that tapering of the Federal Reserve's third round of its quantitative easing programme may begin as early as September of this year. We, however, expect Fed chairman Ben Bernanke will deliver a more dovish message to the market - for several reasons: economic data has still not improved substantially compared to when the FOMC initiated QE3; inflation remains low and continue to decline; and the (premature?) tightening in financial conditions in recent weeks.
There is no doubt that economic data has improved since the FOMC initiated a third round of QE in September 2012. The change in nonfarm payrolls has averaged 197,000 since then compared to 130,000 in the six months preceeding QE3. Also, the unemployment rate has improved to 7.6 percent in May 2013 from 7.8 percent in September 2012. However, employment growth has lost momentum in recent months averaging just 155,000 in the three months through May 2013* (far from the six-month average of 200,000 the FOMC supposedly want to see) and the improvement in the unemployment rate is to some extent due to a further weakening in the participation rate, which stands at just 63.4 percent compared with 63.6 percent in September of last year. Firing has eased - as suggested by the lower jobless claims reports - but hiring is still lacking.
The labour market is not the only part of the economy to watch at the moment: both ISM reports are showing weakness (ISM Manufacturing dropped below 50 in May to 49 for the first time in six months) and the Chicago Fed's proxy for monthly economic activity has fallen below 0 again on a three-month rolling basis suggesting that economic growth is below trend.
Inflation, notably the core price index of personal consumption expenditures (core PCE), which is the Federal Reserve's preferred index, continues to decline year-on-year and now stands quite a bit below the two percent target at just 1.1 percent - the lowest rate of inflation ever according to this measure. In addition, core prices at the consumer level (core CPI) has grown at the lowest rate in almost two years at 1.7 percent year-on-year through April**. Accompanying Wednesday's rate decision at 18:00 GMT will be updated economic projections from the central bank, which we expect will show a downward revision to inflation (and likely also GDP growth) this year.
Furthermore, financial conditions have tightened recently as the markets have begun to price in tapering of QE. The 30-year mortgage rate, for example, pierced four percent a few weeks ago following a sharp increase from around 3.4 percent in early May (the last FOMC meeting was 30 April-01 May). It is not only mortgage rates that have tightened, however, with US Treasury two-year and 10-year yields also higher compared to the most recent FOMC meeting while both AAA and BAA yields have gained approximately 50 basis points.
Therefore, we expect the FOMC to deliver a statement tomorrow that is not too different from the one on 1 May. It will likely highlight that economic data has been somewhat better, but that the improvement is not substantial enough yet to warrant a tapering QE3 from the current pace of USD 85 billion per month. We do not expect tapering to commence in either July or September (the next two FOMC meetings*) unless payroll growth picks up quite a bit in the coming months - something we do not anticipate - and also view October as too early. December looks more likely to our eyes.
* The household survey's measure of employment growth has weakened at an even faster rate to 66,000 per month (on a six-month rolling basis).
** The May report is released later today with consensus expecting unchanged core CPI growth of 1.7 percent year-on-year.
*** FOMC meetings left in 2013: 18-19 June, 30-31 July, 17-18 September, 29-30 October, and 17-18 December.
Here is a video from SaxoTV on the same theme: