Sunday, 8 September 2013

Summer's over, tapering's coming but money is still easy.

I went for a walk this morning - 2 hours before I saw anybody at all. Water levels are low but rising. Summer's over. Stay-vacation visitors to Devon enjoyed the best weather in years in August but the pub is quiet now and the moor is empty.

The chart shows the 3-month average US unemployment rate. I put a trendline through it for fun. The fall in the unemployment rate is progressing at a very steady rate and on the current trajectory, will get to 6.9% by next April, 6.4% by the end of 2014. If the Federal reserve wants to have completed its 'tapering' programme and stopped buying bonds by the time the unemployment rate gets below 7%, they're going to have get going.

A falling unemployment rate is almost always better than the alternative. But the current downward trend is not accompanied by strong GDP growth, or strong real disposable income growth, or inflation Hence the unhappiness in some circles at the idea the Federal Reserve may be thinking about easing back on the monetary throttle.

That brings me back to the trend line. Most Americans, having seen an unemployment rate of 4 1/2% without any major inflation threat in the last cycle, can't see why 7% is the magic number today. Others argue, reasonably, that the unemployment rate is distorted by part-time work, and by people leaving the labour force.

The Fed references unemployment and inflation in its forward guidance for interest rates for two reasons. Firstly, because of a long-held belief there is a relationship between falling inflation and higher consumer price inflation. The evidence is dodgy. And secondly because it believes there is a relationship between inflation and the amount of spare capacity in the economy, but that is too complicated to talk about directly, so the unemployment rate is used as a proxy for describing the output gap. I wish policy-makers would resist the temptation to treat the rest of us as idiots and just say - we will keep policy easy until we're scared growth is so strong it might push inflation up.

The framework to policy does nothing for credibility and helps fuel the debate about where policy should go. But ultimately, the message we are going to hear, over and over again, is that 'tapering is not tightening'. The steady decline in the unemployment rate is going to be one factor, along with the strength of the ISM surveys and the housing recovery, to justify slowing the pace of bond-buying slightly. This month or next month? To my mind that's a tactical decision and in a perverse way, I think the Fed may feel that buying fewer bonds after a period of upward adjustment in yields gives them a better chance that they can slow their buying without causing untoward volatility.  But if they then start to really emphasise the fact that rates are on hold for a lot longer, and point repeatedly to the benign inflation backdrop - the core PCE deflator at 1.4% for starters - we will all eventually realise that monetary policy remains exceptionally accommodative.

Super-easy policy has driven and will drive asset price inflation. The adjustment that came from the shock news that super-easy policy won't really be left in place in perpetuity should begin to come to an end when tapering starts. Some people tell me equity valuations are high, others than M&A makes corporate bonds less attractive. EM outflows continue and maybe that promises more weakness. There are reasons for every single 'risk' asset to remain under the cosh even when the spike in bond yields finishes. But I'm a simple enough fool to know that something is going to have a fantastic autumnal rally on the back of near-zero rates. It would be nice if it were farmland prices, I suppose....

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