At his June 19 press conference, Fed Chairman Ben Bernanke outlined the Fed’s plan to start reducing the pace of bond-buying later in 2013 and to end purchases by the middle of 2014. He conditioned this plan on a substantial improvement in the U.S. labor market, leading to an unemployment rate of about 7 per cent by mid-2014 with an increased rate of economic growth.
There can be no realistic expectation that the U.S economy will deliver on these projections. Over the past 12 months, unemployment has fallen from 8.2 per cent to 7.6 per cent. However, there has been no increase in the ratio of employment to population, no decline in the teenage unemployment rate, and virtually no increase in the real average weekly wage for those who are employed.
The Fed assumes that real GDP will grow by 2.5 per cent during the four quarters of 2013. With a growth rate of only 1.8 per cent in the first quarter and a likely greowth rate of only 1.7 per cent in the second quarter, the growth rate will have to jump to more than 3 per cent in the last two quarters to meet this expectation. And that is well nigh impossible.
U.S. exports are declining in response to weakening demand internationally and to a rising dollar. The Obama tax hike in January coupled to the spending sequester continues to drag down aggregate demand. These effects significantly outweigh the small positive effect on GDP from increased residential investment.
Yet, the market has reacted as if the taper is already in place. As bond yields continue to rise, the aggregate economy will respond in a similar fashion. So it makes a great deal of sense for the Fed to accept expectations and to begin the taper immediately. Such a policy would counter the tendency of investors to seek higher yields in high-risk securities. It would allow normal market forces to return, lifting long-term bond interest rates to the traditional 2 per cent above the inflation rate; or even more, given the debt crisis that continues to overhang the U.S. economy.
‘Do well while doing good’ should be the mantra of an independent Fed. Of course, much depends on the meaningfulness of the word ‘independent’.
Hat Tip: Martin Feldstein, ‘The Fed Shoud Start To ‘Taper’ Now’, The Wall Street Journal, July 2, 2013