Federal Reserve Nerve

Will they have the nerve to do it or won’t they? For the last time in 2013, investors and economists are wondering whether or not the Federal Reserve will finally pull the trigger and announce a reduction in its monthly bond purchases (aka “Quantitative Easing” or “QE3”). According to my non-scientific poll, odds are running at about 50-50.

Those who say that the Fed will act, point to the September FOMC meeting rationale that Ben Bernanke laid out for why the central bankers maintained the status quo. At the time, he cited three concerns that put taper talk on hold: (1) the labor market was still weak (2) the recent rise in interest rates could slow down the economy and (3) lawmakers in DC could throw everything for a loop.

In the subsequent three months, there has been positive movement on all fronts.

1. Employment: Job growth has accelerated, boosting the average monthly gain to over 200,000 for the past three months. Additionally, the unemployment rate has dropped to 7 percent. Way back in June, Bernanke said that an unemployment rate of 7 percent could be a trigger for pulling back on the Fed’s stimulus.
2. Economic slowdown: Despite higher interest rates, the economy is picking up steam. Q3 GDP was revised higher to an annualized pace of 3.6 percent; November retail sales were stronger than expected; and the increase in home and stock prices are combining to increase the so-called “wealth effect,” which should encourage more consumer spending.
3. DC Drama Queens: It may have been a small budget deal, but it was a deal. Congress agreed to increase spending by $63 billion over two years, with the caveat that there will be more than $22 billion in deficit reduction over the next decade. While lawmakers reserve the right to screw things up over the long-term, the short-term pressure is off.

Despite the progress, doubters note that the Fed is still worried that the labor market is not sufficiently healed and that the drop in rate is occurring not just because employment is rising, but also because people are leaving the labor force. Additionally, there is some lingering concern that the low level of inflation is causing anxiety among some central bankers. Then there’s the theory that the Fed may wait until Janet Yellen takes over as Chairman in January, before retreating from five consecutive years of aggressive action. (The Senate is expected to vote on Yellen’s nomination to lead the Fed this week.)

Given what the Fed has told us, now would seem to be the right time to start unwinding the policy. If there is a change to policy, it’s not likely to be anything to dramatic-probably a reduction of $10 to 15 billion per month, evenly split between treasury securities and mortgage-backed securities.

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Image by Flickr User Mr. Velocipede