A look ahead to the FOMC

The Fed meets next Tuesday in order to set the direction of monetary policy, with an announcement following the two-day meeting on Wednesday.

Chairman of the Federal Reserve Ben Bernanke first started laying hints back in May that the Fed is contemplating reducing the size of its monthly asset purchases later this year, should economic data show improvement in the US economy that is in line with Fed forecasts.

Mr Bernanke has been at pains to try and be as transparent as he can about the Fed’s intentions for the next few years with his introduction of forward guidance. This is designed to reassure the financial markets, but this has not always been successful, with volatility spiking after his first mention of the possibility of tapering.

Recent economic data has been fairly strong: a number of manufacturing surveys from different regional Federal Reserve banks have shown that business activity has been picking up this summer (with the notable exception of the Richmond Fed, which saw a contraction), house prices continue to rise and consumer sentiment remains elevated.

A report today from the University of Michigan showed consumer sentiment at its highest level since 2007. The University of Michigan’s Index of Consumer Sentiment moves closely with the business cycle. The US economy, like nearly all developed economies, is strongly affected by how much consumers spend, with over two-thirds of US GDP made up of consumer spending. One way to gauge how much consumers are spending is by looking at how they feel, and such estimates have proven in the past to be good ways of forecasting changes in the economic cycle, with economic activity tending to pick up when the index is consistently high. The index came in at 85.1 today, the best result since July 2007, and it has been up near these levels since April.

Despite these signs of strength in the economy, the Fed is unlikely to move to taper next week for at least two notable reasons. The first is unemployment. The Fed wants unemployment to drop at least as far as 6.5% and so the current elevated level of 7.6%, which it has been stuck at in both June and July, will be a sizeable concern for the committee. As Mr Bernanke has pointed out, that rate also probably understates the problem, as there are people working part-time who want full-time employment and those who are forced to take jobs below their skill level.

The second reason is inflation. Although there have been some small signs of inflation warming up recently, the inflation rate remains well below target. Until the Fed knows for sure that inflation is not undershooting their longer-run objective, they will not ease their foot off the pedal. Committee-member James Bullard, traditionally a hawk, has been very vocal about the need to prevent inflation falling any further.

I would argue that there is a third reason why they will not taper this meeting: they would have flagged the action more clearly at the last meeting. Because of the Fed’s commitment to greater transparency, I would expect Mr Bernanke to make things very clear when tapering is truly imminent (that is, when they think it is going to happen at the next meeting). If they are going to taper in September,therefore, I would expect this to be made crystal clear next week.

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