Economic Commentaries

27

The Federal Reserve's open market committee is soon to meet amidst widespread expectations that the FOMC will agree to reduce the size of its asset purchase program. The only question seems to be by how much. Consensus expectations are currently for about $10-$20 billion with no guarantee that furthers reductions will occur in the future.

There is no question but that the Fed is seeking a graceful exit strategy from its asset purchase program. Chairman Bernanke was the architect of the program and as he prepares to step aside, he would like to begin winding it down before he leaves. There is also considerable research within the Fed that questions the effectiveness of the program. Additionally many argue that the program has created market distortions. Also, given the degree to which the Federal budget deficit is falling, the Fed's purchases of some $40 billion treasuries per month is drying up the supply of new issuance. Finally, both the financial markets and Wall Street analysts have basically given the Fed the green light to proceed.

These are valid considerations but for the most part they are non-economic considerations. So the question for us is whether fundamental conditions in the economy justify a policy change. To be sure, emergency conditions in the U.S. and abroad seem to have dissolved over the past year making the need for extreme policy stimulus less compelling. But upon its initial introduction the Fed installed benchmarks which are not being met. Expectations for a widely acclaimed acceleration of economic growth in this year's second half are already being tempered as job and income growth continually disappoint. Whereas the Fed had identified approximately 200K monthly payroll additions as a threshold, the actual number has been around 160K per month. Meanwhile, wage and salary income actually declined in July with another possible drop being likely for August. Layoffs are no longer in vogue being substituted with furloughs and part-time work.

Beyond this evidence the Fed was clearly surprised by the adverse effect policy discussion has had on market interest rates and further surprised by the effect the rise in market interest rates has had on mortgage demand. Housing has been a tailwind for the economy in the past two years, but it is now threatening to become a head wind which the economy can ill afford. Given this, whatever decision is ultimately reached by the FOMC, odds are high that accompanying language will attempt to convince financial markets that scaling back asset purchases is not a policy change but just a technical adjustment. Fed officials will never admit it, but they must be thinking that there are real costs to its policy of transparency. For financial markets, after this event there is the budget deadline and all the shenanigans surrounding it.

Posted in: General