September taper was coming as of June meeting and the main reasons it didn’t happen were a) dramatic tightening in financial conditions (front end sell off), b) sharp slowdown in payrolls and c) looming October fiscal fight. All 3 have been resolved: conditions eased, payrolls back to trend we saw in June when the fed was ready and willing and the heavy lifting in fiscal fight has been largely resolved without impact on the economy… All these put taper very much back on.
We saved the comment as the best concise argument for why the Fed would taper. We looked back to September’s non-taper in our post below and called it wrong; Rimon looked back to June and got it right. Our attempt to predict the first paragraph of the statement worked for the upgrades (the qualifier “some” was dropped from the labor market sentence and “diminishing” was added to the fiscal restraint sentence), but not for the downgrades (mortgage rates fell back before the meeting and didn’t merit a mention, while the July-October stall in business equipment spending wasn’t noted). Did the FOMC notice the business equipment spending data? Did they notice that the 0.2% drop in the unemployment rate (since their last meeting in October) was explained entirely by labor force shrinkage? We’ll find out when we get the minutes. In any case, we underestimated their commitment to taper.
- To gauge the likelihood of a December taper, we should think through the changes that might occur in the first paragraph of the FOMC’s statement, which is always a brief assessment of the state of the economy.
- While the committee will surely tweak its language on account of last week’s strong jobs data, we’ll see downgrades in other parts of its assessment, which should include a reference to weaker business investment growth and possibly a renewed warning about rising mortgage rates.
- The committee should also be concerned about holiday spending after seeing rapid inventory accumulation in Q3 GDP and other indicators.
- Inventory and spending concerns may not be recognized in the statement, but they’ll add to the case to let the dust settle on the fourth quarter before changing existing policies.
- We expect the tapering decision to be deferred to the next meeting once again.
Thinking like the Fed
To know your enemy, you must become your enemy -Sun Tzu
In war, poker, chess and many other endeavors, wise old hands will advise you to think like your opponent. We’ll try a related idea here by seeing if we can think like the members of the Federal Open Market Committee (FOMC). Specifically, we’ll pretend to write part of the statement for the FOMC’s December 17/18 meeting.
We’ll work through the four or five sentences in the statement’s first paragraph that sum up the committee’s thoughts on recent developments. When the FOMC makes a policy change, it’s always linked to these four or five sentences. Here’s what they said in the last statement (for the meeting on October 29/30):
Indicators of labor market conditions have shown some further improvement, but the unemployment rate remains elevated. Available data suggest that household spending and business fixed investment advanced, while the recovery in the housing sector slowed somewhat in recent months. Fiscal policy is restraining economic growth. Apart from fluctuations due to changes in energy prices, inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.
As you may know, there are at least five pieces to this section: employment, household spending, business investment, housing and inflation. In addition, sometimes factors outside the big five become important enough to make a special appearance. For example, every one of the last six statements included a sentence on fiscal restraint.
We’ll look at each area in up to four steps: old language, new information, comparison and new language. Here are the questions we’re trying to answer:
- Old language: What did the last two statements say? (We’re including the September 18-19 statement because of the surprising decision not to “taper” the Fed’s monthly security purchases and the fact that it was described as a “close call.”)
- New information: What have we learned since the September non-taper?
- Comparison: In view of the new information, how does today’s economy compare to the September 18-19 economy?
- New language: What will December’s statement say?
Once we’ve covered each area, beginning with employment below, we’ll explain why our answers tell us to expect another non-taper.
Old language (October): “Indicators of labor market conditions have shown some further improvement, but the unemployment rate remains elevated.”
Old language (September): “Some indicators of labor market conditions have shown further improvement in recent months, but the unemployment rate remains elevated.”
- Non-farm payroll gains averaged 193K in the last three months (September through November), which is well above the three month averages at either of the last two meetings (148K as of September and 143K as of October). The recent figures included two consecutive gains of over 200K: 200K exactly in October and 203K in November. In addition, the August print was revised upward twice, from 169K to 193K to 238K.
- The household survey tells a different story. The labor force expanded in September while 133K jobs were added, nudging the unemployment rate from 7.3% as of September’s meeting to 7.2% as of October’s meeting. That was a “good” drop in the unemployment rate because it coincided with a growing labor force. Since then, only 83K jobs were added while the labor force shrank by 265K (combining October and November to smooth out government shutdown distortions). Without the labor force shrinkage, the unemployment rate would have held steady at 7.2%. With the shrinkage, it fell to 7.0%. That was a “bad” drop in the unemployment rate because it had nothing to do with new jobs.
- Employment components of the ISM indices were mixed. The manufacturing index’s employment component reached a 1½ year high in November, while the same component of the non-manufacturing index fell to a 6-month low.
Comparison: Nonfarm payrolls strengthened considerably, but these gains aren’t corroborated by the household survey.
New language: The committee is likely to either restore September’s “shown further improvement” (dropping the qualifier “some” from October’s statement) or upgrade the language even more by mentioning an increased pace of hiring. On the other hand, the household survey’s disturbing trends may warrant an extra qualifier. The part about the unemployment rate remaining “elevated” will appear for the 18th consecutive time.
Old language (last 8 meetings): “Household spending advanced.”
- The Q3 GDP report showed household spending growth slipping to 1.4% from a 2.0% trend over the past few years (Q1 2011 through Q2 2013). This is the lowest quarterly print since 2009.
- Spending growth appeared to pick up slightly in October, however, based on Friday’s report showing a 0.3% monthly gain in real personal consumption.
- Preliminary holiday spending reports are tepid at best.
- Monthly car sales averaged 15.6K units in the data released after September’s meeting (for September through November), which is down 1.9% from the monthly average of 15.9K in the prior three months.
Comparison: While the data looks weaker than it did at September’s meeting, the holiday season is the most important piece and still uncertain.
New language: There’s a small chance that they’ll downgrade the language to say that the rate of spending growth has slowed. For this to happen, the December 12 retail sales report would need to be weak. Otherwise, expect to see “household spending advanced” once again.
Old language (last 7 meetings): “Business fixed investment advanced.”
- The Q3 GDP report showed business equipment spending falling slightly (-0.04%). This is only the second negative print since 2009.
- Not only was the third quarter weak, but fourth quarter equipment spending also got off to a poor start. October’s figure for non-defense durable goods ex-aircraft spending, which is used in GDP calculations, was 1.1% below the third quarter average.
- Business spending on structures grew at a 13.7% annual rate in Q3, down from the 17.6% Q2 print but still strong. This is the smallest and most volatile piece of business fixed investment, though, as shown by the year-to-date 2013 data, which includes a drop of 25.7% (annualized) in Q1.
- Like equipment spending, spending on structures is also off to a weak start in the fourth quarter. October’s figure for nonresidential construction spending was 1.1% below the third quarter average.
Comparison: Recent data paints a much weaker picture than at September’s meeting, when the only weak spot was a single month’s data (for July) from the durable goods report.
New language: Expect the new wording to be similar to “growth in business fixed investment has slowed,” which was the language used in December 2012 after the last drop in business equipment spending.
Old language (October): “The recovery in the housing sector slowed somewhat in recent months.”
Old language (September): “The housing sector has been strengthening but mortgage rates have risen further.”
- The Q3 GDP report showed residential construction expanding at a 13% annual rate, the fifth consecutive quarter of double-digit annualized growth.
- The NAHB Housing Market Index has fallen to 54 from 58 prior to September’s meeting and 55 prior to October’s meeting. The November release is due on December 17.
- Housing permits averaged 978K in the last three months (August through October), bouncing back from a three month average of 933K as of each of the last two meetings. Almost all of the fluctuation has been in multi-family units.
- Although the preliminary new home sales release for October was strong at 444K, the last three months averaged only 392K. This is lower than the three month averages at either of the last two meetings (429K as of September and 422K as of October).
- The NAR’s Pending Home Sales Index has fallen for five consecutive months.
- 30-year mortgage rates climbed to 4.46% this week, up from 4.10% in the week of October’s meeting and nearly back to the 4.50% of the week of September’s meeting.
- Housing starts data is conspicuously absent due to the government shutdown, with data for September, October and November due to be released for the first time on December 18.
Comparison: Permits recovered since the last two meetings, but new home sales were disappointing apart from October’s reading. The Housing Market Index and Pending Home Sales Index also weakened. Mortgage rates are rising once again, which will surely get the committee’s attention.
New language: Expect a newly worded housing sentence that retains the cautionary tone of the recent statements. If mortgages rates remain above 4.5%, they’ll probably restore September’s qualifier about rising rates. If rates continue to rise AND the mid-December releases (NAHB index, starts and permits) are weak, the new language should be a clear downgrade from the last two statements.
Old language (last 5 meetings): “Fiscal policy is restraining economic growth.”
New information: The effects of fiscal measures enacted early this year (the tax hike and sequester) will gradually diminish. While new measures could be agreed at any time as budget negotiations continue, fiscal drag isn’t likely to be as severe as it was in the 2013 fiscal year.
New language: The old language could and probably should be softened this month. They could add a qualifier to indicate that the effects are diminishing or eliminate the sentence altogether (less likely).
Old language (October and September): “Apart from fluctuations due to changes in energy prices, inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.”
New information: Core PCE inflation (the FOMC’s preferred measure) fell from 1.2% as of September’s meeting to 1.1% currently.
New language: Same as the old language.
The statement will be upgraded in parts but with a few downgrades mixed in. Overall, it’ll be less sanguine than you might expect if you’ve only been scanning headlines and watching financial television. It’ll reflect disappointing data in areas that haven’t received as much attention as, say, the nonfarm payrolls report, which caused many pundits to forecast a December taper. These more disappointing areas include business investment, mortgage rates and the shrinking labor force.
Based on the balance of upgrades and downgrades, some FOMC members will surely caution against an overreaction to a few months of 200,000+ (barely!) nonfarm payroll gains. They’ll also consider the huge inventory build shown in this year’s GDP reports, which may not be mentioned in the statement but should be part of the discussion. Not only do rising inventories help to explain the consensus outlook for weak Q4 GDP growth, but they also present risks for 2014.
What’s more, it’s hard to judge the fourth quarter without the full picture on holiday spending, which isn’t yet available. The importance of holiday spending makes mid-December an awkward time to form conclusions about the economy’s direction, and that’s especially true this year due to the government shutdown and late Thanksgiving. Some FOMC members will want to wait for the dust to settle on the fourth quarter before making policy changes.
Taken together, these factors suggest another non-taper in December . If we’re right, the spotlight on January’s meeting – which already features Ben Bernanke’s exit, Janet Yellen’s new role and a new set of voters – will be even brighter.
Note: The conclusions above describe our assessment of how the Fed will approach its December decision, not our own recommendation. We’ve offered our own policy perspectives in many other articles, such as here.