The problem with governing by committee is that there can often appear to be a lack of control. There is no dictatorial authority to purge critics and ensure adherence to the party line. However, investors should be careful not to misinterpret the recent vociferous debate on tapering amongst the US Fed officials as a change of tack on quantitative easing (QE). Yes, the Federal Open Market Committee appears to be divided upon the issue of continued asset purchases, but this is nothing new and does not increase the probability of an early change in policy. It may be a committee, but Bernanke and his immediate colleagues have the dominant voice, while the chairman is very sensitive about the dangers of derailing any recovery.
One key factor for the Fed will certainly be the speed of the US recovery. At present, second quarter GDP is only tracking on an annualised growth rate of around 1.25 per cent to 1.5 per cent. That picture of a slow growing economy is the one the Fed will have when it makes its decision in Q3. Even if the true underlying strength of the economy is more like 2.0 per cent, that would still not be enough to warrant a rapid removal of any accommodation. For the Fed to be sufficiently confident to tighten policy, it would probably require a six month period of 3.0 per cent, plus growth.
A critical consideration for any policy change then will be the sustainability of any improvement in the economy. To that end, a self-sustaining recovery, which would negate the need for government assistance, would require sufficiently strong job and credit growth, neither of which is presently in place. Jobs growth has picked up, but not at a sufficient rate to bring the unemployment rate down meaningfully. The Fed has signalled a 6.5 per cent unemployment rate as a target for a change in policy, with the proviso that inflation was also below 2.5 per cent. More recently, though, Bernanke has highlighted that other measures of the labour market, such as the total under-employed, are the most appropriate gauge of labour strength, or otherwise. The implication here is that the labour market hurdle is rather higher than the basic unemployment rate would imply.
As for credit growth, while it has been expanding, a large element of this has reflected student loan growth. Apart from this, auto loan growth has been firm, but credit card growth has yet to pick up. On the corporate side, the senior loan officers’ report noted an improvement in loan standards, but not due to better economic prospects, more a function of enhanced competition.
All in all, conditions for a self-sustaining recovery are not yet in place. One blessing for the Fed is that it is not constrained by inflation. If anything, weak inflationary pressures are giving the Fed a clear mandate to focus on getting economic growth up and running again.
Part of the ongoing debate within the Fed reflects the concern amongst some central bank officials that the asset purchase program is potentially damaging economic prospects. QE could be distorting key economic variables, for example, keeping interest rates below where they might otherwise have been. Whilst there may be some substance to these concerns, they are not new and there is little evidence that such risks are rapidly rising.
In contrast, there has been a clear positive from QE in terms of its impact on net wealth, which has in turn contributed towards decent consumer demand growth. In the 2009/2011 period, as stock market values picked up, this trend was almost wholly beneficial to the upper income brackets. Over the past 18 months, though, the impact of higher house prices has benefited a broader range of income groups.
To sum up, what would persuade the Fed to pull back some of its present policy accommodation? The first requirement would be strong and sustained falls in unemployment and underemployment, for example regular job growth preferably above 200,000 a month. A pick-up in credit demand (outside housing, autos and student loans) would be a second requirement. Finally, sustained annualised GDP growth between 2.5 per cent and 3 per cent per year – for at least two quarters – may also be required. Our present economic growth forecast of 2.5 per cent for 2013 and 3 per cent for 2014 would therefore see policy tightening in the first half of next year, with the Fed potentially making announcements this autumn.
The recent noises from the Fed illustrate that its policy of embracing diversity of views remains intact. However, the idea that Bernanke will not be able to build a consensus for his easing instincts appears highly unlikely. Instead, we would argue that investors will need to pay close attention to the central mass of Fed policy making rather than focusing on the satellite views. All in all, as long as the growth outlook is uncertain and inflation is undershooting, the balance of risk favours unchanged policy.
Douglas Roberts, Senior International Economist, Standard Life Investments
