Outside of the uncertain direction of fiscal policy in the United States, the big question on the mind of most traders, investors, and economists has to do with monetary policy. Through its ongoing program of quantitative easing, in which it is purchasing $85 billion worth of agency mortgage-backed securities and longer-term securities each month, the U.S. Federal Reserve is pouring liquidity into the market in the form of low-cost credit.
The intended consequence of accommodative monetary policy is to lower long-term interest rates and stimulate economic activity. Ostensibly, easier access to credit has encouraged U.S. consumers to move forward with big-ticket purchases such as automobiles and homes and has incentivized businesses to pursue growth instead of sitting on their hands. To some degree, this is what happened. Interest rates have been relatively low, car sales have been strong, and for a period — until taper talk pushed interest rates higher — mortgage refinancing and applications were surging.
But the stimulus can’t last forever, and every market participant wants to know when the flow rate will be reduced. When will $85 billion in monthly purchases turn into $75 billion? When will $75 billion turn into $65 billion? These changes will have a significant impact on financial markets in the U.S. and abroad, and an understanding of this timeline is necessary to navigate the transition smoothly.
The Fed has made no secret of the metrics and benchmarks it is using to determine when the right time to taper would be. When QE3 evolved into its current form last December, Fed policymakers announced that they would continue purchases as long as inflation expectations did not rise above 2.5 percent and as long as headline unemployment trended above 6.5 percent. At a glance, these may seem like clear guidelines, but the reality has been anything except clear.
Unemployment fell to 7.3 percent in October as the economy added 204,000 new jobs, but the headline data are packed with some conditions that shouldn’t be overlooked. Perhaps most importantly, at 36.1 percent of the total unemployed, long-term unemployment remains an enormous problem, and monetary stimulus is unlikely to have a material impact on this kind of structural unemployment.
The labor force participation rate has also fallen significantly over the past few years, and has fallen by a full percentage point over the past 12 months. This has put a sort of artificial downward pressure on the headline unemployment rate. Reductions in the labor force participation rate mean fewer people are looking for work because they have likely given up. If labor force participation continues to fall, the Fed could revisit its 6.5 percent unemployment guideline.
Inflation is the other part of the equation, and most indicators show that price pressures are soft, at best. The price index for personal consumption expenditures increased just 0.1 percent in September, which follows identical increases in August and July. The PCE price index was up just 0.9 percent on the year in September and up 1.2 percent excluding food and energy. Energy prices have largely declined this year, down 3.3 percent in September.
Compensation costs data confirm weak inflationary pressures. On Tuesday, the U.S. Bureau of Labor Statistics reported that compensation costs for non-farm civilian employees increased a seasonally adjusted 0.4 percent in third quarter of 2013. Compensation costs are usually the largest expense for a business, so even small increases in compensation costs can result in price increases being passed on to consumers. However, the 0.4 percent increase recorded in the third quarter was relatively soft and consistent with economist expectations.
Wages and salaries, which make up 70 percent of total compensation costs, increased 0.3 percent, while benefits costs increased 0.7 percent.
In July, the BLS reported that health benefits costs increased 2.6 percent on the year. This was down from 3 percent in the first quarter.