Taper(ing) Talks

EDIT:I misrepresented the position of most analysts. They were referring to the qualitative easing part and not the entire QE part. My apologies,especially TD Economics since I linked their research. The latest FOMC meeting from July (FT link here) voiced concerns and disagreed on what to do with the threshold of unemployment, a view that I’d echoed in this post.

From my impression in forum discussions of analysts,forecasters and traders in the investment community, it seems like some are expecting the Fed to taper down its QE programme on September. This view is also echoed by TD Economics, and they argued that the removal of Fed Support has been priced in (10 year bond yield went up by 100 basis points), with about 10-20 basis point (0.1-0.2 %) to be priced in across the yield curve when “”tapering” ¬†materialises, which is anticipated to occur in September.

Interestingly, the forecasted Federal Funds Rate is expected to remain at 0.25% through the end of 2014.
The forecast implicitly recognises that the following 3 conditions are expected to hold through 2014 then, which are enumerated by the Fed on scenarios that makes it appropriate to have a 0-0.25% Federal Funds Rate target:

  • the unemployment rate remains above 6.5 percent,

  • inflation between one and two years ahead is projected to be no more than 1/2 percentage point above the Committee’s 2 percent longer-run goal, and

  • longer-term inflation expectations continue to be well anchored.

Which raises an interesting question from my end, is this really talks on the tapering of Quantitative Easing(expanding the money supply) or Qualitative Easing (tilting the Fed’s Open Market purchases towards risky assets? ).

In the beginning, the change in Federal Funds Target Rate to influence short term rate is becoming less potent as we approach the zero bound (what is the difference between 0 and 0.25%?), and so instead of swapping reserves for short-term treasuries, the Fed had to experiment by swapping short-term Treasuries for long-term treasuries to make long-term borrowing cheaper (Operation Twist), before expanding into purchasing Mortgage Backed Securities to support housing prices (let’s just call this Qualitative Easing, since these assets are riskier. I did not make this term up, it was referred to this by a Macro Prof in an exam I wrote.) So how do we reconcile these forecast figures with the exit condition of the Fed? The only logically consistent view is that the taper talks are on the withdrawal from Qualitative Easing programmes and Operation-Twist like programmes. If one wants to argue that Quantitative Easing is heading towards its end, the .25% Federal Funds forecast cannot be justified. (Unless it’s your birthday, then you can both have the cake and eat it, but that day is not today!)

Aside: Nobody really talks about the Repo market anymore eh? Except the good folks at FT’s alphablog. I recommend following those posts and comments on the Repo market discussions.

Today,I’d like to focus my attention on discussions on the first condition, the unemployment rate. This is an issue that fascinates me, primarily because I am entering my senior year with an Arts degree and have been over the course of the summer, regaled with woes of the unemployed by friends who have graduated.

In all seriousness though, I think this is one of the most widely discussed yet poorly examined variable by the press. In fact, discussions on unemployment had annoyed the Fed that a tool is specifically designed to help people track the Fed’s assessment of conditions on the labour market. If you are interested in unemployment 101, Jodi Beggs has a good post on it at About.com.

Before I began my study on unemployment I’d thought that unemployment during the recession is driven by mass firing, that is, an increased inflow into unemployment. I was also under the impression that prolonged recession and persistent unemployment is caused by increased layoffs. I was wrong. While mass-firing (inflow into unemployment) does go up when a negative shock hits the economy, it is actually the outflow (difficulty in finding jobs) from unemployment that makes a recession prolonged and unemployment rate persistently high. Have a look at the graph I took from Sahin and Patterson’s post from the New York Fed’s blog.

Inflow and Outflow

Moreover, I think most of the unemployment rate discussions have also missed a crucial dynamic factor -the flow from non-participation to the labour force (although I think the Fed is very concerned with the development of this factor, since it was stressed that the current unemployment rate “understates” the health of the labour market.). Let me put it this way, when the survey is conducted and you say that you have given up finding a job, you are technically not considered to be part of the labour force, and so you don’t enter into the unemployment statistic.

So what deadline should we set? I don’t know. What I know it shouldn’t mechanically follow the 6.5% threshold, since ignorance of the flow from non-participation to the labour force and underemployment risks the removal of support as the economy is recovering. A strict adherence to the threshold without context is akin to patting yourself on the shoulder for bailing out water on a sinking boat without addressing the leak.

I wonder if anyone is working on modelling agent’s decision to enter and drop out of the labour force, and whether there are empirical studies that show how they react to the vacancy yield etc?

Gossip Corner:

1. John Taylor is still selling the Taylor Rule.

2. Stephen Williamson tries to make sense of the “announcement effect” and is skeptical of the QE accomplishments.

Just to drive discussion on Williamson’s post. If we think of the interest rate as being driven by short term real interest rate (IS-LM intersection, or return on capital) + Expected Inflation + Term Premium, wouldn’t the figure sort of make sense? i.e. recovering economy drives up real interest rates, while expected inflation remains same or decreased, and term premium increases because of withdrawal from Qualitative Easing. Then qualitatively, the yield movements do make sense.


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