This morning’s employment data were not dramatically out of line with the current trend. They did, however, fall meaningfully short of expectations—especially at a point in the recovery where data have historically tended to surprise to the upside. And even though nothing about this crisis and recovery maps to other periods we have lived through, this has to be seen as a significant disappointment.
But it would be wrong to think that this will significantly alter the Fed’s reaction function come September 18th.
Beyond the obvious that the Fed—unlike those of us in the market—is unlikely to overreact to one data point, there are three reasons why the Fed is likely to stick to its current course and that odds still favor a September tweak to their current policy stance (read taper).
One, the Fed thinks in balance sheet terms. We in markets are slaves to flows, but the Fed all along has said that to the extent QE has a mechanistic effect on financial conditions it comes through reducing the available stock of USTs and mortgages to financial institutions and the broader investing public. And the fact the yields have tended to go higher when the Fed initiated purchases under its series of programs, but each time to lower highs—notwithstanding improvement in the economy—supports its case. In short, the Fed doesn’t view taper as reducing accommodation.
Two, the Fed is increasingly cognizant of the data that suggest QE has passed through to the real economy much less than its staunchest proponents hoped. At the same time collateral costs—though far, far smaller than hard money advocates had forecast—have been creeping higher. At home, markets have been distorted in exchange for less benefit. And abroad, to paraphrase the famous John Connolly quote: the Fed is our monetary policy, but your problem. Both the risk and the reward may have turned out smaller than many hoped/feared, but be that as it may the risk-reward equation still continues to drift away from more QE. And the Fed gets this.
Three, it’s all about the signal. QE has triggered significant effects in markets and indeed helped buy precious time for household balance sheets to heal and animal spirits to revive. This has been an important contribution. But it is now clearer that the primary channel through which this has taken place is psychological. Most everyone now knows that the money “pumped in” by QE has largely remained as reserves on the balance sheet of the Fed. The money that “flowed” into asset markets here and abroad came from us, not the Fed, as our risk appetites increased.
It was virtually impossible for the Fed to have gauged ex-ante the magnitude of our psychological response to its easing. But because the market response has been so large yet the economy is still far from where the Fed would have hoped to see it by this point in time, the weaning of market psychology off of the Fed teat now has to be handled in a balanced and incremental fashion. Signaling will play a central role in this process.
The Fed already took the first step in this process. Many Fed members seem anxious for the data to let them take that next step. And this morning’s data won’t do much to alter this monetary landscape.