The Week In The US : Resolutions

The Fed was early with New Year resolutions, committing to QE3 in September and to low rates in December. As for now, it broke neither of promises, confirming all pledges at the March FOMC meeting.

Meanwhile, the Congress, in due time, passed a continuing resolution to keep the federal government running until the end of the current fiscal year, relieving some stress. The next dead line is now on May 19th, when the federal debt ceiling will be reinstated. The Congress now has a little less than two months to decide on a new ceiling, as it will be automatically hit at that time. When it suspended the ceiling in January, the Congress also decided that, when reinstated, it would equal the previous amount augmented by the Treasury's issuances over the period. The piece of law also set the obligation for both chambers of Congress to pass a budget for next fiscal year. Were they to fail, Congressmen would not get paid, the money being transferred on an escrow account instead.

As for now, budget committees of both chambers proposed budgets which look impossible to reconcile. The House's proposals are for a balanced budget ten years from now, thanks to dramatic cuts in spending, both discretionary and mandatory, the later thanks to a reform that would turn Medicare into a premium-support voucher and raise the age of eligibility from 65 to 67. The Senate draft plans for tax increases. Both pledges for the elimination of tax loopholes. In the next few weeks, the White House will add its own proposition to the debate.

The federal government will not shutdown this time, which is indeed a great relief, as these events are highly disruptive, but the fiscal outlook remains rather blurred, an additional reason for the Fed to be as clear as possible. At the March 19th and 20th meeting, the FOMC reiterated the same message as of lately. The third wave of quantitative easing will keep on being implemented at the exact same monthly pace of USD 40 bn of MBS and USD 45 bn of long-dated Treasuries. The Fed Fund Target remains in the 0-0.25% range, and will be kept there as long as the unemployment rate does not break the 6.5%-threshold (which is not a trigger as Chairman Bernanke reminded us), unless prospects are for inflation to accelerate above 2.5% within a 1 to 2 year horizon.

The Fed also released the update forecasts from FOMC members (voting and non-voting) for GDP growth, the unemployment rate, the pace of increase in the PCE deflator (headline and core) as well as the likely timing of policy firming and the likely level of the Fed Fund Target over the next two years. On balance, Fed members seem slightly less optimistic about GDP growth but slightly more confident about the pace of decrease in the unemployment rate. As for inflation, they largely forecast that the 2%-target will be missed this year, next year and the year after. Only one or two members expect PCE inflation to be higher than 2.5% in 2015 (at 2.6%), leaving large rooms of manoeuvre to the Fed. The focus will remain solely on the labour market.

The question is about judging the progress of the labour market conditions. A few weeks ago, Vice-Chairwoman Janet L.Yellen gave a list of indicators to be watched: the pace of job creations, the evolution of the unemployment rate, the strength of growth in activity, and the hire and quit rates. During his press brief, Chairman Bernanke added to the list initial claims and wage growth. From that information, we built indicators that allow judging the trend of the overall set of data in just one chart, but two lines: the Janet Index and the Ben Index.

Both are moving up, even if the Janet Index paints a way rosier picture. According to that gauge, Miss Yellen appears less dovish than Mr Bernanke. However, both indices are unquestionable too low for comfort. The target is difficult to estimate, but we assume that the Fed would like to see them moving up to the average level of the 2003-07 period (the median levels have been dramatically lowered with the crisis, and are then irrelevant). One standard-deviation below the 2003-07 average could see the Fed ending QE3, while the Fed Fund Target would be lifted when that level is hit. Our forecasts for activity and employment would put the first event in early 2014 (with a slowdown in monthly purchases starting in the late summer) and the second in... mid-2015. The forward guidance got more complicated and potentially more flexible, but actually did not move a notch!

Indeed, and as shown by the distribution of the appropriate timing of policy firming, a huge majority (13 members) views 2015 as the right time: only 5 members would prefer to tighten sooner. Among them is probably Esther L. George who dissented from the decision, as she did in January, voicing her concern that “the continued high level of monetary accommodation [might] increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations”. She is a lonely hawk on a dovish board.

BY Alexandra ESTIOT