Is Another Round of Quantitative Easing Coming?

Today was a special Jobs Day Tuesday as the Bureau of Labor Statistics released the September jobs report, which had been delayed due to the government shutdown. It wasn’t very good. Total non-farm payrolls increased by 148,000, which was less than the expected 180,000, while the unemployment rate dropped from 7.3% to 7.2%. The labor force participation rate remained unchanged at 63.2%. The July (-15,000) an August (+24,000) revisions combined for an increase of 9,000 jobs.This report was disappointing, but what’s even scarier is the trend lines.

Here’s the three-month moving average going back to the end of 2011:

3 month moving averageThere’s a pretty good chance that something is wrong with the way the BLS seasonally adjusts the numbers. Every winter has been much better than the following summer, but the trend is still not good. We’re into Obama’s second term and the economy is still barely growing. The reasons for this aren’t clear, but the government likely has a lot to do with it. Sequestration is terrible policy that is taking a chunk out of the economy at the wrong time. Austerity is the last thing we need right now. The expiration of the payroll tax cut at the start of this year is likely having some effect as well. And, of course, shutting down the government and risking a default is about as boneheaded as it gets. Instead of constructing policies looking to get the economy back going, the federal government (read: Republicans) have stood in its way.

The Federal Reserve has been concerned about fiscal policy and chairman Ben Bernanke has repeatedly emphasized that Congress needs to do more. Except that’s never going to happen. The question then is will the Fed do more? The economy is slowing down, not recovering. The FOMC had hinted at tapering in September, but pushed it off due to weak data and the impending fiscal fights. The market had assumed that the Fed was going to reduce its bond purchases regardless of the underlying data. By delaying the taper, the central bank attempted to regain its credibility and prove to investors that it’s data-dependent. Now, this is another test of that credibility.

This was a bad report and the economy is trending downwards. More fiscal fights loom and sequestration will be worse in 2014 than it was this year. Inflation is still running well below the Fed’s 2% target. If the Fed is really data-dependent, it will seriously think about making its policy even more accommodative either through QE4 or another mechanism.. The economy is no longer improving at a moderate pace. It’s slowing and there’s no chance that fiscal policy will help. It’s time for the Fed to pick up the slack.

The Unemployment Rate is Just One Indicator

One criticism of the Fed’s recent communication strategy has been that it relied too heavily on the unemployment rate as an indicator of the health of the labor market and communicated that reliance to the market. As I wrote earlier, the unemployment rate is falling, but the economy is barely improving. In his June prepared statement, Fed Chairman Ben Bernanke said:

And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains

The Fed projections at the time expected the unemployment rate to be at 7.2-7.3% in the fourth quarter of this year. In August, the unemployment rate fell to 7.3%, well ahead of the Fed’s projections. Except this was not the result of above-average economic growth. On the contrary, financial markets tightened and the August jobs report was disappointing.  The drop in the unemployment rate was not representative of the overall economy.

Bernanke had hinted that the unemployment rate would be around 7% when asset purchases fully ended, but it had not even begun tapering yet. That was one major reason that so many journalists and investors expected the taper last week. Yet, this is once again not the Fed’s fault. The central bank could have done better in a number of areas. The long silence from the Fed governors provided little guidance for investors and Bernanke should have emphasized more that the Fed uses many different pieces of economic data to judge the labor market, not just the unemployment rate. But fundamentally, this was the market misreading the Fed.

Investors took one economic indicator and assumed the Fed would base its monetary policy on it. Worse, they knew that the drop in the unemployment rate was not the result of improving economic growth. It should have been common sense that the Fed would not that into account. But it wasn’t. There’s no doubt the Fed and Bernanke could have been more clear, like NY Fed president BIll Dudley was today and Bernanke was in his press conference last week. There, the chairman emphasized that the Fed looks at other economic indicators as well:

Last time, I gave a 7 percent as an indicative number to give you some sense of, you know, where that might be. But as my first answer suggested, the unemployment rate is not necessarily a great measure in all circumstances of the–of the state of the labor market overall. For example, just last month, the decline in unemployment rate came about more than entirely because declining participation, not because of increased jobs. So, what we will be looking at is the overall labor market situation, including the unemployment rate, but including other factors as well. But in particular, there is not any magic number that we are shooting for. We’re looking for overall improvement in the labor market

Too many commentators overreacted to what Bernanke said in June. The 7% unemployment rate number was treated as a trigger, not a threshold, even as Bernanke emphasized that it was the opposite. The unemployment rate was treated as the pivotal economic indicator influencing Fed decision-making. If you take a step back and look at the economic growth the past three months, there were few reasons the Fed would taper and many it wouldn’t.  The most important thing is that the economy underperformed Fed expectations. Yet, it was conventional wisdom that the taper was coming. That doesn’t mean Bernanke couldn’t have been clearer in June, but it means it was a fundamental misreading by journalists and investors. The Fed’s over-reliance on one economic indicator doesn’t change that.

Everyone Is Misreading The Fed Again

Well almost everyone. The conventional wisdom right now is that the Fed delayed tapering to fix its miscommunication in its June statement. The argument goes that the Fed should never have mentioned tapering and it was correcting itself by not cutting back its bond-buying. Here’s Bloomberg’s Justin Wolfers:

Chairman Ben Bernanke promised that future quantitative easing would depend on the incoming economic data. Those data clearly have been weaker than most analysts, including the Fed, had hoped. The only way for the Fed to convince markets that its policies are data-dependent is to make data-dependent decisions. Let’s hope this episode has helped rebuild some of the Fed’s credibility.

This whole taper debate is one that should never have happened. It’s the result of a failed communication strategy.

The point is that “taper off” doesn’t really represent an interesting new policy easing, but rather its main function is to undo the damaging tightening in financial conditions that occurred following the initial taper talk.

Wolfers analyzes the underlying situation correctly, but gets to the wrong conclusion. He says that the Fed is data-dependent and the economy worsened slightly over the three months in between the Fed’s June FOMC statement and its one two days ago. That should lead the market and investors to believe that the Fed would not taper, but it didn’t because none of them truly believed the Fed would adjust its policy based on the data.

The failed communications strategy wasn’t a Fed error. It was a forecaster error. I went back and read through the transcript of Bernanke’s June press conference last night. Every single time he mentioned tapering, he prefaced it by saying something like “if the incoming data support the view that the economy is able to sustain a reasonable cruising speed” or “[i]f the incoming data are broadly consistent with this forecast.” And guess what? The incoming data was NOT broadly consistent with this economic forecast.

This is where Tim Duy and I disagree. He writes:

I think this means that, in general, the data was broadly consistent with the Fed’s expectations.  That is, we weren’t reading the data wrong.  They just decided that they could wait until longer before initiating the taper.

The September FOMC statement did not do a good job of indicating that the data came in slightly below the Fed’s economic forecast. But Bernanke laid it out clearly in his prepared remarks:

in evaluating whether a modest reduction in the pace of asset purchases would be appropriate at this meeting, however, the Committee concluded that the economic data do not yet provide sufficient confirmation of its baseline outlook to warrant such a reduction. Moreover, the Committee has some concern that the rapid tightening of financial conditions in recent months could have the effect of slowing growth, as I noted earlier, a concern that would be exacerbated if conditions tightened further. Finally, the extent of the effects of restrictive fiscal policies remains unclear, and upcoming fiscal debates may involve additional risks to financial markets and to the broader economy. In light of these uncertainties, the Committee decided to await more evidence that the recovery’s progress will be sustained before adjusting the pace of asset purchases.

The Chairman is saying two things here: (1) the rise in interest rates since June have already lead to a tightening in financial conditions and (2) the potential for a government shutdown/default makes the Fed cautious. Overall, the Fed reduced its economic growth forecast slightly. Bernanke is explicitly saying that the financial data is not consistent with their June economic forecast. The Fed is adjusting its policy as the state of the labor market changes.

That’s why I think Duy and other journalists are misreading the data. The job reports have been mediocre at best. The labor force participation rate has declined. Average hourly earnings and average weekly hours have barely budged. The Commerce Department first revised its GDP numbers down from a 2.4% annual rate to one of 1.8% and then revised them back up to 2.5%. Mortgage rates have risen quite a bit.  All of these are indicators of a barely growing economy, one growing slower than the Fed expected in June.

In particular, the rise in mortgage rates happened as a result of the Fed’s June FOMC statement. Slate’s Matt Yglesias writes that “[t]he punchline is that the tightening of financial conditions in recent months was caused by … rumors that the Fed was going to taper.” Except there weren’t any rumors. There was the June statement that explicitly repeated over and over again that the Fed would only taper if economic data was positive. The market read that to mean that the Fed was going to taper no matter what and interest rates rose. Because interest rates rose, the economic data worsened and the Fed followed through on its promise to adjust its policy based on the labor market. If the market had read the Fed correctly and not assumed the taper was coming, rates wouldn’t have risen as much and the Fed’s economic forecast would have been sunnier. That may not have been enough to overshadow the other mediocre economic data, but the market also wouldn’t have completely expected the Fed to scale back its bond-buying. The non-taper wouldn;t have been a shock. The Fed and market would’ve been in sync. Instead, the market’s blind assumption that the Fed wouldn’t react to the data forced the Fed to do just that. Bernanke’s remarks didn’t cause the tightening of financial conditions. The market’s misreading of them did.

Once again, journalists are misreading what the Fed is saying. Bernanke isn’t saying that he regrets mentioning tapering in June. He regrets that the market misread him. That’s what the Fed was trying to correct this week. It was trying to tell the markets that it really is going to listen to the underlying data. It was trying to regain its credibility by precisely adhering to the statement it laid out in June. But, no one is hearing that. Everyone is misreading the Fed yet again.