From Mike O’Rourke of Jones Trading
Drum roll please … Tomorrow is the big day.
Market participants have been primed and prepared to watch for any changes to the Fed’s forecast. The current Fed forecasts for key metrics are as follows. The 2013 Unemployment Rate is 7.4%. For the 2014 Unemployment Rate, the Fed is forecasting 6.85%. The Fed’s 2013 real GDP forecast is 2.55% and its 2014 forecast is 3.15%. The game plan that Fed watchers have telegraphed is as follows. If the Fed’s economic forecast remains unchanged, the reduction in the amount of QE purchases (a.k.a. tapering ) should commence in September or October. If the forecast is raised, then look for tapering to commence in July or September. If the economic forecast is lowered, then tapering is pushed back to December or 2014. The charts below illustrate the Consensus Forecast and the Fed’s forecast for the Unemployment Rate and real GDP for 2013 and 2014.
There is a belief among many in the market that now that the Chairman has jawboned the equity market sideways and the bond market down, the Fed will back off. The thinking is now that bond yields are rising (including some rates), the Fed would like to remain low, and the Chairman could indicate tapering is postponed. We believe this thinking is the result of having a Fed Chairman for 7 years who has done nothing but ease. To be fair, when his tenure commenced the Chairman did finish Chairman Greenspan’s tightening cycle in early 2006. When it came to ending QE or Twist in the past, the end dates were all clearly telegraphed early on in the program. The process for QE3 has been quite different. We don’t ascribe to the Pavlovian view that the Fed will continue to postpone the inevitable. That being said, the belief in the Fed’s lack of tightening credibility has paid handsomely over the years.
We expect the forecast to remain unchanged and the reduction in asset purchases to commence in the Fall. Let’s start with the premise that the Unemployment Rate forecast carries the most importance per Jon Hilsenrath’s WSJ article. Although the Fed’s forecasts have often been way off base and far more optimistic than Wall Street economists, the Central Bank’s Unemployment forecast has been its strength in 2013. The Fed’s 7.4% is only a rounding error away from the street’s 7.5%. Before the uptick to 7.6% in May, the Unemployment Rate low ticked at 7.5% in April. The Fed’s Summary of Economic Projections provides, “Projections for the unemployment rate are for the average civilian unemployment rate in the fourth quarter of the year indicated.” As such, with the current rate at 7.6%, it is very likely the rate is at or below the Fed’s 7.4% target by year end. For additional context, the Unemployment Rate dropped by 80 basis points in 2011 and 70 basis points in 2012. Similar drops for 2013 and 2014 would place the rate at 7.1% and 6.6% respectively. Those are not forecasts, but simply illustrations that the Fed forecast is quite reasonable. Another key factor in the Unemployment Rate argument is the growing belief that the decline in participation is demographic and less job creation is necessary to bring down the rate.
The Fed’s far less successful forecasting has been in the realm of real GDP. As the charts below illustrate, the Fed has been far more optimistic than street expectations or reality. The Fed forecast has been consistently 35% above the street forecast. So while there is room for the Fed’s GDP forecast to come down, it is at the same premium to consensus it has been for the last couple of years.
The final reason that we believe the Fed will keep the forecast intact (thus indicating tapering) is because of the drama. The Fed has rightfully been the target of a great deal of criticism for how the “taper talk” has been managed. Does Bernanke want to continue to drag this out, or leave if for the next Chairman? We don’t think so. So what did the Fed do? It went and told Jon Hilsenrath and Greg Ip exactly what to tell the market to look for. That way everyone has the same expectations and theoretically, the same interpretation of the data. In typical Bernanke fashion, he has set the expectations stage without ever making a statement or taking ownership. Thus, if there is adverse reaction, he has deniability, but if the reaction is benign, he has started tightening (although he will claim it is easing) and the market accepted it.