The U.S. Federal Reserve released the minutes of the December 17-18 meeting on Wednesday, and they reveal that the taper debate is in full swing at the nation’s central bank. The effectiveness of the Federal Reserve’s highly accommodating monetary policy has diminished, and policymakers know this. Monetary stimulus has evolved from being the medicine that helped financial markets and the broader economy get through the crisis to a drug. It now appears to service an unproductive addiction to easy money more than the favorable dynamic of job creation, rising income, and increased spending that Fed Vice Chair Janet Yellen spoke about in her recent testimony before the Senate Banking Committee.
For this reason, and because the economy is soldering through a slow but real recovery, the Federal open Market Committee announced at the conclusion of its December meeting that it would reduce the flow rate of assets being purchases for quantitative easing. Policy makers also dropped the floor on the unemployment component of its forward guidance, stating that, “It likely will be appropriate to maintain the current target for the federal funds rate,” which is at a range between 0 and 0.25 percent, ”well past the time that the unemployment rate declines below 6-1/2 percent.”
The taper — which reduced asset purchases from $85 billion to $75 billion per month — was widely expected, but the edit to the unemployment target was more of a surprise. Where the taper means a lower dose of stimulus for beleaguered markets, the more flexible target reassured market participants that the Fed would be careful not to withdraw support too quickly.
The minutes of the December meeting reveal that Fed policymakers debated over the details of the taper, including the revision to forward guidance. The decision to taper was made “in light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions.” Labor market conditions have improved fairly steadily over the past several years, but at a headline rate of 7 percent in November, unemployment, particularly long-term, “remains elevated.” This compares against a full employment target of between 5.2 and 5.8 percent headline unemployment.
The revision to the unemployment target suggests — as do more direct comments from Bernanke and crew — that the Fed is aware of and possibly worried about the effectiveness of the headline unemployment rate as a target. In particular, a 3 percentage point decline in the labor force participation rate since the financial crisis has put downward pressure on the headline rate, making the labor market appear healthier than it actually is.
The central bank indicated that it will continue to look at alternative measures of labor market health. One such measure is the employment-to-population ratio, which was 58.6 percent in November, well below pre-crisis levels of about 63 percent. Meanwhile, the Fed is projecting headline unemployment to fall to a range between 6.3 and 6.6 percent in 2014, and to a range between 5.8 and 6.1 percent in 2015, with full employment reached sometime after 2016.
With the revised target in mind, markets are expecting Fed policy to remain accommodating for a long time to come. QE could taper out as early as the end of this year – a Bloomberg survey of 41 economists found that the expectation is for seven incremental reductions in the rate of asset purchases over the next seven meetings — and most Fed policymakers are looking at 2015 as the target year for any firming of the federal funds rate.
This means that short-term interest rates will likely remain low at least through 2014, while mid- and longer-term interest rates rise as the taper progresses. The yield on the benchmark 10-year Treasury note closed trading on Wednesday at 2.993, down from a high of just above 3.0 at the end of December but still at pretty much its highest level in two years. Some economists and analysts expect the yield to climb by about half a percentage point this year.
As far as inflation is concerned, the Fed appears unworried, despite the fact that the pipeline appears devoid of pressure. The Fed projects both headline and core PCE inflation in 2014 of between 1.4 and 1.6 percent, with the lower bound edging up to 1.7 percent and 1.8 percent, respectively, by 2016. Inflation as measured by the consumer price index has also been soft, trending below the Fed’s target.