Waiting on the Fed: Chairman Ben Bernanke. Photo: Reuters
Little else matters. Equity, credit, and exchange markets have already priced in a $US10 billion ($10.7 billion) cut in the Fed’s $US85 billion rate of bond purchases each month. They expect tapering of US Treasury bonds rather than mortgage bonds in order to keep the housing recovery alive.
The neuralgic issue is whether the Fed lowers its unemployment target or “threshold”. This would mean loose money for longer, shaping the trajectory of interest rates far into the future. “The real drama is if the Fed does more than taper,” said HSBC’s Daragh Maher.
The Fed has a two-phase trigger. It aims to wind down bond purchases to zero as the headline jobless rate nears 7 per cent, and then start to raise rates at 6.5 per cent. The problem is that unemployment has been dropping faster than expected. It is already 7.3 per cent and could hit 7 per cent soon. This would be fine if the economy was roaring back and creating jobs, but it is shedding jobs at a disturbing pace.
Headline unemployment is dropping only because people have stopped looking for work. America lost 347,000 jobs over the past two months, with the labour “participation rate” falling from 63.5 per cent to 63.2 per cent, the lowest since the late 1970s when fewer women worked.
The Fed’s voting body appears split on whether this slide in participation is because the economy still needs stimulus, or whether there is a deeper “structural” cause predating the crisis that is impervious to easy money policies. This could be happening because of the switch from “brawn to brain” as technology evolves, leaving the least educated behind.
Economist Tim Duy from Fed Watch said the bank is “moving towards an epiphany” on the jobs debate, concluding rightly or wrongly that the problems are structural. This puts it on track for rapid tightening.
San Francisco Fed chief John Williams, previously seen as a dove, raised eyebrows earlier this month by suggesting the problem is structural, partly caused by ageing baby boomers drifting off the rolls. The message is that the jobs market with tighten soon, stoking wage pressures. The “non-accelerating inflation rate of unemployment” is higher than supposed.
Mr Williams said the Fed should stick to the headline jobless rate, and left no doubt he thinks quantitative easing is causing asset bubbles. If this is the majority view, the Fed now has a hawkish bias and may raise rates faster than the market expects. This would send tremors through the global financial system.
Alain Bokobza, from Societe Generale, said the Fed will prove tougher than expected, triggering a sharp fall on Wall Street. The S&P 500 index will fall from its current 1705 to 1475 in the fourth quarter. There will be further capital flight from emerging markets. The yield on 10-year US Treasuries will rise to 3.5 per cent by next June. “US equities are not immune to higher bond yields. Gold is particularly vulnerable.”
John Davies from Standard Chartered said the signal to be sent on Wednesday is crucial. “If they cut the unemployment target to 6 per cent, this will push out rate hikes by another nine months,” he said.
But such action would leave the Fed open to accusations that it is shifting the goalposts, and may be waiting too long to nip inflation in the bud. It is damned if it does, and damned if it doesn’t.