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The outcome of next week’s FOMC meeting appears to be a very close call. We still see January as the most likely date for the first taper, but between January and December it is increasingly looking like a coin flip. The recent round of economic data could convince many on the Committee that the conditions set for tapering at the September FOMC meeting — which itself was a close call — have been met. In particular, employment growth has accelerated, GDP growth appears healthier, fiscal uncertainties have diminished, and financial conditions better reflect the distinction between tapering and tightening. Perhaps the only economic condition not to move in the right direction is inflation, which has further decelerated in the months since September. Moreover, while many of the economic conditions have been met, risk management considerations could lead the Committee to judge that the recent up-tick in the data has not persisted long enough the generate the required sense of sustainability of that improvement. End-of-the-year liquidity conditions could also be an argument for holding off until January, albeit a secondary one.
If the Committee does decide to taper next week, we think that action would be coupled with the addition of an inflation floor, namely, pledging not to raise rates if the outlook for inflation one to two years ahead is below 1.5%. Given the earlier-mentioned deceleration in inflation, an inflation floor would allow the Fed to taper without being accused of taking its eye off the ball with respect to downside inflation risks. Another quite possible option is to strengthen the verbal rate guidance by talking about headwinds or optimal control considerations as motivating a gradual expected pace of policy normalization. We see other communications options as less likely, including cutting IOER or lowering the unemployment rate threshold. Since a taper next week might still come as a modest surprise to the markets, we think they would opt for a small move at first, with a maximum reduction in the monthly flow rate of $15 billion, though possibly smaller, and with a bias toward reducing Treasury purchases more than mortgage purchases. We don’t think the interest rate forecasts — the dots — will be a communication tool to mollify the market reaction to tapering. Those forecasts are formed before the meeting, and we believe the asset purchase decision is uncertain and will be made at the meeting. (More on the forecasts below).
If the Committee decides not to taper next week, we view the meeting as an opportunity to put more foam on the runway, by further preparing the market for a tapering as soon as the following meeting. We think the preferred venue for doing so would be in the post-meeting press conference, where the Chairman could convey that it was a close call and that only a limited amount of further information is needed to persuade the Committee of the sustainability of the labor market improvement. Guidance along these lines is also possible in the statement, though we think the press conference may be a better place to convey the subtlety of the message. We see a no-taper decision as less likely to be accompanied by any material innovation in communications, as the desire to strengthen and clarify forward guidance is largely motivated by a concern about distinguishing tapering from tightening.
Regarding the Summary of Economic Projections (SEP) we have a hard time seeing how the FOMC could lower the “dots” indicating where Committee participants see the funds rate in the future. The growth outlook for next year may actually be a touch firmer than in September, when the middle of the central tendency for 2014 was 3.0%, and we also see the unemployment rate forecast getting nudged down. We foresee little change in the inflation forecast. Given this evolution of the economic forecasts, we see little rationale for a significant change in the interest rate forecasts.
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