A strong December U.S. jobs report has fueled speculation on the possibility of a taper of asset purchases in December or January. However, job numbers are not clear-cut for a change in Fed policy.
The latest U.S. jobs report showed that the unemployment rate fell from 7.3 to 7.0 percent, beating expectations. This brings the rate down to the level Federal Reserve Chairman Ben Bernanke indicated back in June might warrant an initial reduction in monthly asset purchases. The strong numbers have spurred speculation that the Fed might announce a small reduction (or “taper”) in the current $85 billion a month in bond purchases. Back in September, markets heavily anticipated a taper announcement, only to be shocked when the Fed judged that the data had not indicated a strong enough improvement in the U.S. economy to pull back.
Positive gains point to taper
In addition to a drop in the unemployment rate, the preliminary report of 203,000 jobs added in November upped the average over the last year to 195,000 a month. Data on unemployment insurance claims — released a day before the jobs numbers — showed that the four-week moving average fell to just over 322,000 (see graph below). This brings the monthly trend down to pre-recession levels after a pickup around the federal government shutdown.
More impressively, the number of unemployment insurance claims fell to a six-year low. Unemployment insurance claims are usually seen as a leading (or concurrent) indicator for the wider unemployment rate, bolstering the credibility of the drop in the unemployment rate.
At the last Federal Open Market Committee (FOMC) meeting in October, the post-meeting statement indicated that while the economy had improved, more evidence was needed to determine that “progress will be sustained.” The recent jobs and unemployment figures might just be that evidence to prompt the FOMC into action.
Remaining weaknesses
However, the picture is not that straightforward. Several other factors argue for more patience with the bond buying program. While the gains in employment have been more impressive (or rather, less depressing), the participation rate, which shows the percent of those in the work force who are employed, has been on a downward trend.
This means that some of those employment gains are actually coming from workers giving up on job hunting and being considered out of the work force. This raises concerns that the unemployment situation may not be improving as much as initially seen.
In addition, the inflation rate remains stubbornly low. This may seem like a positive thing, but the Fed is concerned that a low inflation rate may pose a risk to the recovery. While high inflation can be a destructive force, deflation can be even more so. If consumers expect prices to continue to drop, some may hold off on purchases until prices fall further. By increasing the value of the dollar over time, deflation prompts savings over consumption.
This can act as a check on economic activity – a scenario that Japan is struggling to escape from even now. The Fed’s preferred measure of inflation, the Personal Consumption Expenditure (PCE) price index, fell to 0.7 percent year over year in October. The “core” PCE index which excludes volatile food and energy prices, remains low at 1.1 percent. Two percent is generally considered a prudent level of inflation and the U.S. remains far from it.
Prospects for Fed action
So what might the Fed decide to do? The market has widely varying expectations. A recent survey of economists showed that almost half expected a December or January taper, but a majority saw the March meeting as the more likely possibility. Charles Evans, President of Federal Reserve Bank of Chicago, indicated that he could support trimming purchases this month but would rather wait. James Bullard, another voting member of the FOMC, has pointed to labor market data as raising the possibility of tapering. However, he seemed to think a “small taper” would be advisable.
There is a chance that the Fed will announce a reduction in purchases and accompany that with a change in their forward guidance to ease the impact on markets. A paper by Fed researchers presented at the IMF’s annual research conference argued that dropping the unemployment threshold at which the Fed would raise interest rates to 5.5 percent or 6.0 percent would boost the recovery (it is currently 6.5 percent).
The minutes from the October FOMC meeting showed that members discussed this option for improving their guidance. “A couple of participants” favored a simple reduction in threshold, while others favored promises to maintain low rates even after the current 6.5 percent threshold is crossed. Another possibility discussed was to end the interest rate the Fed currently pays on bank reserves. While it is very low, the interest rate might be prompting banks to hold reserves rather than lending out funds.
New data to be released this week will be closely scrutinized for further positive signs on the economy. If the Fed moves in December, look out for the possibility that the it might only reduce Treasury purchases and continue buying mortgage-backed securities to support the housing market. It would be fitting if Ben Bernanke began the end of the program that he helped build before he hands the reins over to Janet Yellen at the end of January.
