Wednesday, June 18, 2014

Janet Yellen’s Fed Playbook

The U.S. Federal Reserve is opaque at the best of times. Even their jargon-filled efforts at transparency, called “forward guidance,” only add to the confusion about their intentions regarding monetary policy. Yet there are times when careful study of personalities and public statements combined with a good working knowledge of Fed models and methods can yield important clues about their future course of action. This is one of those times.

Since 2008, the Fed has been engaged on a stop-and-go basis in a program of money printing known as quantitative easing or “QE.” The current round of money printing, called QE3, began in September 2012 and had been proceeding at a pace of $85 billion per month. In December 2013, the Fed started to reduce, or “taper” the printing The current pace is $45 billion per month and the market expects the taper to continue in stages until the money printing reaches zero late this year. But will it?

The Fed has said repeatedly that the taper is data dependent and not on a pre-set course. The pertinent data for this purpose involves economic growth, unemployment, inflation and related indicators. The taper began on what seemed like a wave of good news with strong growth and declining unemployment. But that growth proved ephemeral, and disappeared completely in the first quarter of 2014. The declining unemployment rate proved meaningless because it was driven by dropouts from the labor force as much as job creation. Recent data has continued the bad news with a fall in consumer confidence, weak retail sales, and weak industrial production. In short, the case for tapering is weak and the case for a pause in the taper is strong.

The Fed’s remaining policy meetings this year are in June, July, September, October, and December. The Fed will not pause in June because the April employment numbers were superficially strong and even a bad report for May will not be enough to throw the Fed off course. If the Fed does not taper in July, they will no doubt stay the course and finish the taper by December. So, July becomes the pivot for Fed policy in 2014. If they pause, it will be in July; if they don’t pause in July, they won’t pause at all. How can we handicap the July move?

Ironically, Yellen’s own instincts lean toward pause. The Fed has a dual mandate of price stability and reducing unemployment, which Yellen takes to heart. She is heavily influenced by labor economist Andrew Levin who believes that unemployment is cyclical rather than structural in nature. Levin also says that those who have dropped out of the labor force need more stimulus to get jobs than those who are merely unemployed.

Combining these factors reveals that Yellen is determined to reduce unemployment, believes she has the monetary tools to do so, and believes she must print extraordinary amounts to overcome the inertial effect of low labor force participation. This is a recipe for a pause, and later a return to increased money printing.

A countervailing factor is that Bernanke tied Yellen’s hands by starting the taper in December before she was in charge. It’s politically difficult for a new chairwoman to rock the boat so early in her tenure.

This is where personalities matter. Fed Chairwoman Janet Yellen is not a dictator. She must develop consensus on the Federal Open Market Committee, or FOMC, the group that makes policy. The FOMC usually consists of eleven members made up of seven Fed governors and four regional reserve bank presidents who rotate in the position. Historically, the reserve bank presidents are more hawkish than the Fed governors, meaning they generally support the taper and oppose a pause.

Right now, there are 3 vacancies on the Board of Governors, which means the FOMC only has 8 members divided equally between governors and regional presidents. Two of the regional presidents, Charles Plosser and Richard Fisher, are super-hawks. As a result of the vacancies and the rotation, the current FOMC is quite hawkish. So the bar for a pause is high. What would it take to cause the Fed to pause in July?

Basically bad data would have to run the table. If we see a combination of weak employment reports for May and June, disinflation or outright deflation, sharply declining labor force participation, and preliminary signs that second quarter GDP will be much weaker than consensus expectations, then the Fed will pause in July. But if any of these data points come in strong, the taper will continue in July and beyond. The key data will be available by early July in advance of the July 30 announcement by the FOMC.

With or without a pause in July, change is on the way. President Obama has nominated two new governors, Stan Fischer and Lael Brainard, to fill the board vacancies. Both are likely to be dovish and amenable to Yellen’s wishes. The two hawks, Fisher and Plosser, will rotate off the board in 2015 to be replaced by two doves, Charles Evans and Dennis Lockhart. In short, a dovish FOMC is in the cards for 2015.

The showdown comes in July. If the data between now and then are uniformly bad, the Fed will pause and then increase money printing in 2015. If the data are mixed, the Fed will finish the taper this year. But this does not alter the fact that the fundamental economy is weak and the taper is exacerbating the weakness. If the Fed does not pause in July, they will revert to money printing in 2015 to offset the weakness. Either way, look for QE4 in 2015.

If the Fed pauses in July, look for stocks and gold to rally strongly in the second half as it becomes clear that the Fed can never stop printing. But, if the Fed finishes the taper, looks for stocks to go lower in 2014 with high volatility as the taper does its damage. Gold may find some strength in spite of the taper due to buying by India, China, Russia and Iran as the geopolitical situation continues to deteriorate for the U.S. dollar. When QE4 is launched in 2015, gold will get a second wind and stocks will rally in tandem. By then it will be clear to all that Fed money printing has passed the point of no return.

- Source, James Rickards via Darien Times

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