When Exactly Will The Tapering Begin?

Since the FOMC’s June 22nd meeting, markets have been in turmoil. Commentators and Fed watchers have been speculating about exactly what Chairman Bernanke was trying to say on behalf of the Committee. When I commented shortly after the meeting, an astute reader pointed out that I had incorrectly reported that Chairman Bernanke had indicated the asset purchase program might begin to be phased out when unemployment reached 7%. In fact, he indicated that by the time the program had ceased, unemployment would be at 7% sometime in the middle of next year. The import of this remark is critical, especially given that the publicly available FOMC central tendency forecast for unemployment by the end 2013 is 7.2-7.3% and by the end of 2014 the central tendency is an optimistic 6.5-6.8%. If the Chairman meant what he said on behalf of the Committee and its forecasts are realized, then the entire phase out of the asset purchase program would be completed by mid-2014. Hence, the inference markets drew was that the FOMC is poised to begin very soon. This possibility is what riled markets.

But not so quickly! It seems that not all FOMC participants see things the way the Chairman reported. We know St. Louis Federal Reserve Bank President James Bullard went on record saying that he thought the discussion of the phase out was “ill-timed.” Because of his concerns about deflation, he would prefer to retain monetary ease for some time, and this includes the asset purchase program. But now other voices have been added to the chorus. President Narayana Kocherlakota of Federal Reserve Bank of Minneapolis stated in in a press interview and in a document on the Bank’s website that he would prefer to consider starting the phase out of the program using 7% unemployment as a trigger not the end point. He attempted to redirect the public’s focus away from the asset purchase program, which he and the Committee apparently view as a relatively small and quantitatively insignificant component of its accommodative policy. While this view of the policy may be the Committee’s perception, it clearly doesn’t reflect the view of market participants.

So what is the Committee’s decision as to when the phase out will begin, and how long will the phase out process last? What is the trigger? Is there even a trigger? Whom should one listen to? Following Bullard's and Kocherlakota’s statements, numerous FOMC participants have offered their own clarifications, all of which look remarkably coordinated, with a Roseanne Roseannadanna-like message: “Never mind.” Meaning, “We aren’t going to change the Funds rate anytime soon.”

What we have witnessed is a remarkable miscalculation on the part of the FOMC in terms of their communications strategy and forward rate guidance. Their messaging reflects an under-appreciation of what constitutes information meaningful to markets. Telling markets that a policy move depends upon incoming data is neither informative nor is it forward guidance.

What markets want to know are the answers to two questions:1) what incoming data will be used to make decisions and 2) how will policy depend upon those incoming data? For example, does the decision rest on reaching a critical value in the unemployment rate, the participation rate, or some other trigger? If it rests on the unemployment rate, then what does the Committee view as the most likely path for the unemployment rate to hit the critical trigger? Annual forecasts such as those released after the last meeting are largely meaningless, especially since there is an apparent disconnect, at least to this writer, between the projected path for GDP growth on the one hand and estimates for job creation and unemployment on the other. Growth would have to be accelerating greatly by the end of 2013 to come close to hitting the FOMC’s optimistic unemployment forecasts for 2014. Yet there is a dearth of evidence supporting that view.

Markets are like math teachers, they don't just care about answers. They also want to see the work that led to the answers to ensure that the reasoning makes sense and everything adds up. Ultimately, they need actionable information. Anchoring the Committee’s communications efforts in more detailed forecasts would greatly improve things.

Markets fret for data-driven answers to the kinds of questions that drive investment decisions and their timing, and they will not be satisfied with fuzzy answers, especially fuzzy answers that don't add up. For instance, how does the Committee expect to respond to changes in an indicator variable like the unemployment rate? Does it expect to cut back Treasury purchases by $5 billion for every 0.1 percentage point improvement in the unemployment rate? Or perhaps the Committee has some other calibration in mind?

If it doesn’t have such a plan in place, then it shouldn’t say “it depends on incoming data.”

BY Bob Eisenbeis