Macro and Markets

Yesterday’s decision by the Federal Reserve’s policy committee to modestly reduce (“taper”) its purchases of U.S. Treasury and mortgage-backed securities was a turning point in a number of respects.  After a long period of public debate that roiled markets, the Federal Reserve has at last begun what is likely to be a gradual and well-telegraphed exit from its period of extraordinary stimulus.  Together, last week’s fiscal deal and the Federal Reserve’s taper decision appears to have marked the start of a period of relative calm where U.S. macro policy uncertainty will be far less of a driver of markets. That’s good news for the global economy. A few observations on the decision. The decision yesterday to cut purchases by $10 billion to $75 billion represents a very small reduction in stimulus–worth just a few basis points on the long-term interest rate—and was easily offset by a more dovish statement and forecast for the future path of policy (“forward guidance”).  Equity markets rose on the announcement and Treasuries held their ground.  The Volatility Index (VIX), a measure of market uncertainty, fell 15 percent on the news. The Federal Reserve may see the response as reflective of its credibility; maybe, but it also reflects that the decision was significantly priced into markets and underscores the value to markets to resolving uncertainty. The path outlined by the Federal Reserve yesterday, a steady and gradual reduction in purchases (likely ending sometime in mid-to-late 2014) followed by a “liftoff” in rates sometime in 2015-16, means that policy remains highly accommodating and will only incrementally tighten. Even after purchases end, the Federal Reserve’s large balance sheet means that policy remains easier than if they had simply stopped when interest rates hit zero.  Policy remains data dependent, but one month or two of good data will not change this bottom line. Global inflation pressures remain muted and, given the amount of slack globally, is likely to not be a problem for policymakers in the near term.   The Bank of Japan will likely have to do more next year to meet their 2 percent inflation target.  The Federal Reserve’s move turns up the heat on the ECB—I expect we will see quantitative easing (QE) in Europe next year.  While Bernanke rightly highlighted that there were transitory factors helping to constrain inflation that could be reversed, the more likely scenario is that central banks will continue to worry more about deflation.  That too will introduce “stickiness” to policy. Looking ahead, forward guidance will be a relatively more important tool of policy, and QE less important.  This parallels a shift among economists—inside and outside the Fed—in thinking about what is most effective at influencing financial conditions.  Simply put, successive rounds of QE were less effective, relative to the potential benefits to credibly committing to maintain low rates for a long period. Forward guidance will be data dependent and markets will continue to price in changing expectations about the future.  But the payoff to clear commitments will tend to make policy changes more cautious and, hopefully, well telegraphed and therefore less noisy for markets. The Federal Reserve yesterday needed to address its former guidance that an unemployment rate of 6.5 percent was a threshold for considering a rate hike, something it may regret having said as the unemployment rate has fallen faster than expected. Some expected a lowering of the threshold to 6 percent, but the Federal Reserve instead shifted to a qualitative commitment:  “that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.”  This was a clever way to get the message out while softening the focus on the unemployment rate going forward. As we know from its minutes and speeches, the Federal Reserve Board has been sharply divided on the question of tapering.  It should come together now.  Certainly there will be disagreements over how much to taper at any individual meeting and how to communicate, but these differences seem small compared to the debate that has played out over the past year.  It often has felt that Federal Reserve communication reflected as much a negotiation in public among Fed members as it was forward guidance to the public.  If so, this decision will make Janet Yellen’s communication task easier, and would be another reason why the taper decision was well timed. Over the past few years, both monetary and fiscal policy has been an extraordinary source of uncertainty.  Last week’s fiscal package took one set of risks off the table, and while the debt limit extension could be noisy (an increase is expected to be needed in March but could be stretched till May/June) the incentives for another crisis seem low for both parties. Now we have a monetary policy framework that markets seem to understand and welcome.  Together, the reduction in uncertainty could be quite constructive for investment and growth.

I recently returned to the gym after a long hiatus. It was a nightmare to behold, and I ached for days. It’s easy to be critical for what I haven’t been doing, but it was good that I went. Something to build on. So too with last night’s fiscal package announced by Patty Murray and Paul Ryan. It is too easy to criticize the deal for what it did not do: this isn’t a grand bargain, and it doesn’t address our critical long term deficits—fiscal, education, infrastructure and the like. Critics on the right will dislike the new revenue, and the left will be dismayed that public workers have been hit again and that extended unemployment benefits lost its best vehicle for renewal. It doesn’t even take another shutdown off the table, though Chris Krueger of Guggenheim Securities reduces the odds of a shutdown in January to 15 percent.  He has a good discussion of the deal here and a summary of the deal is here and here. My ambition for the negotiations at the start was modest: do no harm, and give markets and the general public some breathing space.  Honestly, I didn’t expect agreement on funding levels till the January 15 deadline when the current continuing resolution expires.   Instead, we have a deal that increases spending this year by $45 billion and next year by nearly $20 billion, significantly more than I expected.  There are a few points worth noting. The deal freezes discretionary spending at slightly over $1 trillion for the next three years. Assuming we continue to have divided government, it is hard to see much change. The negative is that the burden of deficit reduction has fallen too heavily on discretionary spending.  The positive could be stability and an exit strategy from repeated crises. In real terms, this means fiscal policy will be a continuing, though diminishing drag on the economy in coming years. The added spending was partly paid for through having federal workers hired after December 31, 2013 pay more toward their retirement.  This approach, which differentiates future beneficiaries from current ones, isn’t formally an entitlement reform (the pension is the entitlement, not the premium), but it is close enough to give a sense of the discussion to come. Similarly, having businesses pay higher premiums to the federal government to guarantee their pension benefits, and reducing cost of living increases for those under age 62 who retired from the military, seem to cross formerly bright red lines. Both Murray and Ryan in their comments tried to change the terms of the taxes versus entitlement debate, with Ryan talking of success at addressing the recurring spending. Further, about half of the savings come from additional revenue, though both sides have agreed to call it "fees" and "contributions," not taxes. This looks like good politics, if it works. Next up is the debt limit, which is locked on February 7.  If Treasury fully uses a high cash balance and the extraordinary measures available to them, they should be able to extend the debt limit (the “X date”) to May or June, at which point Congress is likely to provide another short-term extension to beyond the mid-term elections. This deal is what governing looks like.  If approved, it provides breathing space for markets.  And it was done ahead of the absolute deadline, a rarity in DC. Something to build on.