Tapering: Groupthink trips up Fed watchers
Comb back through reports and analysis filed by sell-side analysts in the run-up to the Federal Open Market Committee meeting on September 18 and you’ll struggle to find any predicting that the Federal Reserve would continue apace with monthly purchases of agency MBS and Treasury securities.
True, we might tip our hats to Michael Hanson and Brian Smedley at Bank of America Merrill Lynch who, two days before the meeting, saw a strong case for the Fed to delay tapering until December. But most analysts had encouraged investors to price in at the very least a token taper of perhaps $5 billion to $10 billion last month. None that Euromoney has found confidently predicted that the Fed would simply keep going, for now, at $85 billion a month.
In the aftermath of a decision Fed watchers described as a shock came the wailing and gnashing of teeth. One of Euromoney’s favourite strategists, Jim Reid at Deutsche Bank, bemoaned caving in on his summer-long call that the rate of nominal US GDP growth in the first two quarters of 2013 would not justify tapering. He fell in with the consensus 10 days before the September meeting, fearing that the near-unanimous conviction behind imminent tapering meant he must have been missing something.
This is groupthink in action.
At least one can sympathize with the key lesson Reid draws from the Fed’s surprise call not to taper: that no one outside the Fed is particularly well connected to what the US central bank is actually thinking. So investors might do well to treat with a fist-size pinch of salt the immediate re-casting of analysts’ incorrect predictions for a $10 billion to $15 billion taper in September to come instead in December.
Euromoney has heard from plenty of bank economists that not only should the Fed have tapered by now but that, with growth running at well over 2% this year and on track for 3% next and with the Fed itself predicting 2.5% inflation one to two years ahead, it should, in accordance with the Taylor rule, have raised the short-term Fed funds rate well above the prevailing 0% to 0.25% range. "The Fed is making a big mistake," one tells Euromoney.
It seems bizarre that in an era of more explicit central bank forward guidance, with eventual US rate rises being tied explicitly to achievement of a 6.5% unemployment rate from the present 7%, such decisions can still catch market participants out.
The first explanation the Fed offered for not tapering last month was its concern over tightening monetary conditions in the US. Rates had risen sharply in June largely in response to what the market perceived as the Fed’s own guidance over the spring towards tapering in the fall. So this all seems a little muddled. And for all that bank strategists’ credibility has been diminished by last month’s decision, the credibility of the Fed’s own communications has been more seriously damaged.
With changes now imminent at the top of the Fed and in the composition of the FOMC in the months ahead, decisions of the most important player in financial markets aren’t likely to be any easier to predict in coming months.
The Fed’s spring guidance towards tapering had coincided with warnings from the Bank for International Settlements that markets had fallen under the spell of monetary easing, with the obvious danger of asset bubbles. When bond yields surged in June, the Fed, European Central Bank and Bank of England very quickly said in July that policy would remain accommodative until recovery was assured. It is a shame, although it is hardly news, that monetary stimulus has more effect on financial markets than real economies. But there was a big clue there for market analysts that they all missed.
Once again, last month, the BIS warned that continued declines in credit spreads and increased issuance of riskier bonds after July was "a phenomenon reminiscent of the exuberance prior to the global financial crisis". This is extraordinarily explicit and damning language from the BIS.
Three days later the Fed chose not to taper. If it sees another slump in the growth rate back below 2%, that’s not reflected in its public projection. But one or two sell-side analysts now suggest tapering might be delayed until next March. And some economists at investing institutions, now dismissing the views of their sell-side counterparts, whisper to Euromoney their expectation for an increase in quantitative easing next year.
Does the fabled US recovery remain largely stimulus-dependent? The only prediction Euromoney is confident about making is that bond markets will be volatile.