The Fed’s September Surprise

The Fed surprised the markets yesterday by keeping the rate of QE asset purchases on hold, contrary to the widely telegraphed intention to taper them this month. The Fed’s forward guidence says that the fed funds target will not move from where it is now until unemployment goes below 6.5%. Given that ending QE must precede any change to the fed funds target (technically, they could raise the IOR rate and keep QE going, but that would be pointless as the extra cash would just wind up in excess reserve balances), it stands to reason that the current unemployment rate near 7% gives ample reason for the fed to at least slow down the pace of asset purchases. Fed speak over the summer signaled such an intention pretty clearly, hence all the taper talk and the focus on this month’s meeting.

So why didn’t the FOMC taper yesterday? One aspect of their reasoning surely has to do with the employment numbers themselves. U/E is a poor proxy for underlying growth when most of the recent reductions have been due to a decline in the labour market participation rate rather than the creation of new jobs. Recent downward revisions to the payroll numbers also point to a less robust labour market than previously assumed.

But there is a more interesting dimension to this decision. In the first paragraph of the statement the committee says (my emphasis):

Some indicators of labor market conditions have shown further
improvement in recent months, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has been strengthening, but mortgage rates have risen further and fiscal policy is restraining economic growth.

Fiscal policy is mentioned again in the third paragraph. My bet is that when the minutes to this week’s meeting are published at the end of October they will reveal an FOMC very concerned that recent political events have increased the odds of a drawn out budget showdown later this year.

There is a theory that the fed alters policy to offset what congress does to the budget, rendering the fiscal multiplier impotent (regardless of your neoclassical or Keynesian theoretical preconceptions). I think that this is true, at least for the last five years, and what this means is that Fed policy today is influenced by what happens on Capital Hill far more than is commonly supposed.

If you adopt this perspective, today’s decision makes allot of sense. What has changed over the last month? A foreign policy circus by the Obama Administration, and a huge realignment of priorities with respect to how the administration intends to spend its dwindling political capital.

Larry Summers’ withdrawal from the Fed chair job was the first signal. Well, actually, the first signal was the leak on Friday, 13 September to an Asian paper that the Administration would announce Larry’s appointment the following week, a piece of information that should have actually lowered one’s probability of his appointment. Why would the White House feel the need to telegraph if they weren’t concerned that Larry might not get through congress?. Days later, Larry withdraws. These are signs of a weakened Obama administration.

No, the shift in the Fed’s stance had nothing to do with anticipating a Yellen chairmanship instead of a Summers one. It had everything to do with the failure of POTUS to get his man through congress and what that signals for the budget fight with House Republicans later this year (according to the CBO the debt ceiling will need to be raised by October or November of this year). That, I gather, is the reason why fiscal policy has such prominent place in this month’s FOMC statement.

So there you have it folks, a gambit by Obama on Syria caused the fed to taper the taper talk. This brings new meaning to the term “macro economics”, but I think that it is true, and interpreting Fed policy is going to have allot more to do with the budget than the economic stats for the next quarter or two at least.