The employment report put the December taper squarely on the table. But what about inflation? Does low inflation take the December taper off the table? That is the question I asked last week, and Gavyn Davies at the FT follows up on the theme. Davies draws attention to this line from the FOMC statement:
In judging when to moderate the pace of asset purchases, the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective.
As Davies notes, surely low inflation must create a headache for central bankers desperately seeking to taper. In the US, not only is inflation not trending back up to the Fed’s objective, it is actually trending away from the objective. St. Louis Federal Reserve President James Bullard acknowledges the difficult position the Fed finds itself in:
While labor market outcomes have been considerably better than those predicted at the time of the September 2012 decision, Bullard noted that inflation has surprised to the downside. “There is no widely accepted reason why inflation is running as low as it is in the face of extraordinarily accommodative policy from the Fed,” he said.
They don’t know why inflation is falling, only that it is. What should they do with respect to policy? Bullard offers a solution:
“A small taper might recognize labor market improvement while still providing the Committee the opportunity to carefully monitor inflation during the first half of 2014,” Bullard said. “Should inflation not return toward target, the Committee could pause tapering at subsequent meetings,” he added.
The tiny taper is back. What makes this extraordinary is that Bullard is an inflation hawk in the sense that he typically defends the inflation target from above or below. He is believed responsible for this addition to the FOMC statement:
The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance…
Seems like he is easing back on his low inflation concerns, perhaps thinking that inflation *must* turn upward soon considering the decline in the unemployment rate.
Note, though, that he offers up the tiny taper in the context of leaving the asset purchase progam data dependent. Other policymakers, however, want to shift the QE to a calendar dependent program. This I suspect Bullard would only be willing to accept if inflation was on a clear upward trajectory.
Bullard also discussed options for forward guidance:
He discussed three possible options for altering forward guidance, including lowering the unemployment threshold. However, Bullard cautioned, this “puts the credibility of the thresholds approach at risk.” He said another option would be to establish an inflation floor at 1.5 percent, which would be symmetric with the current forward guidance on inflation and which could be helpful if inflation continues to behave in an unusual manner. The third option would be to state verbally that the FOMC is unlikely to raise rates even after the 6.5 percent unemployment threshold is crossed, which Chairman Ben Bernanke has already done. This option is “less complicated and possibly just as effective,” Bullard said.
There seems to be a general resistance to changing the unemployment threshold, in part I suspect because there is lingering concern that the Phillip’s Curve will rear its head before unemployment hits 5.5% or even 6%. And I would think that the erratic behavior of inflation is exactly why they would avoid tying their hands with an inflation floor. After all, arguably the “erratic” behavior of unemployment has already given them enough of a headache. I tend to think the FOMC will come around to the third option of verbally reinforcing the existing thresholds. It is indeed less complicated, as Bullard notes.
Bottom Line: The Federal Reserve wants to taper. Wants very badly to taper, in my opinion. The recent employment reports seem to be giving a green light, and I suspect they are coming around to the idea that the decline in the labor force participation rate is largely permanent at this point, which will only increase their angst about the asset purchase program. But inflation is a thorn in their sides. The Fed will need to do a 180-degree turn on its current inflation concerns. If they dismiss the inflation concern in their drive to taper, I suspect they will lean on the stable inflation expectations and Phillips Curves arguments to justify a forecast that has inflation quickly reversing course and trending to target. I still tend to believe the Fed will delay tapering until 2014. Whether December or January or later, policy is close to an inflection point with a shift from more to less accommodation in the works.