By Vincent J. Truglia
As my readers know, I am against the Fed tapering anytime soon. All the arguments in favor of that view were outlined in my September 2nd blog entitled Fed Tapering Would Be A Big Mistake.
I was pleasantly surprised to find that the FOMC voted at the September meeting to not taper. However, despite the fact that the vote appears to be favoring my position, I still believe the Fed will begin tapering before year-end.
The reason for this view has nothing to do with correct monetary policy per se, but rather on my observation of how committees operate. For over three decades, I sat on innumerable bank credit committees at three major commercial banks, and countless rating committees at Moody’s. I have been a participant, co-chair and chair of these committees. Given that experience with how committees operate in practice, here is my take on why Fed tapering will soon begin, and what will determine the likely date.
Why No Tapering In September?
Chairman Bernanke clearly let it be known in May, that he was prepared to begin tapering later in the year. I accept him at his word. What changed? Two things: 1) The economy didn’t appear as strong in September as it had seemed to be in May; and, 2) Washington gridlock created a horrible confluence of politically-sourced financial cliffs.
Regarding the first point, all my views detailing the economic weaknesses are outlined in the September 2nd blog: Fed Tapering Would Be A Big Mistake
Many vital new statistics will not be released before the October FOMC meeting. We won’t get the advance estimate for Q3 GDP growth, and more importantly, the GDP and PCE deflators until October 30. However, despite this, I don’t think economic weakness was the real driving force in the September vote. Rather, it was the issue of gridlock.
Gridlock Is Key
Yes, there was economic weakness, but the FOMC could have fulfilled market expectations by beginning a small, basically irrelevant taper, perhaps in the $5-10 billion range. That wouldn’t have caused much harm, especially if at the same time the FOMC voted to adjust the mix of asset purchases by reducing its purchases of US Treasuries, and increasing its purchases of MBS, so vital to a still relatively credit starved housing market.
Watching Bernanke’s news conference after the September announcement, what struck me the most was how often he mentioned fiscal drag and issues surrounding the budget and the debt ceiling.
What was even more important was that quickly after the September meeting, the generally dovish St. Louis Fed Governor James Bullard quickly sent a message that the Fed would possibly be prepared to begin tapering as soon as the October meeting. The statements by Bullard are especially striking because, although Bullard believes that there is a risk of deflation, something the Fed would really like to avoid, more importantly, he was at the FOMC meeting. It appears to me that despite his own personal views regarding correct monetary policy, he was sending a message that, despite his past statements, the FOMC was likely to start tapering relatively soon.
Strong Hints Of Future Action
Since little would have changed regarding available statistics before the October meeting, what would have led Bullard to go out on a limb and discuss a possible tapering as early as October? I assume he went away from the FOMC discussion recognizing that the majority of committee members would have voted for tapering, but for the crisis over a continuing resolution and the debt ceiling. The resolution of the first could increase fiscal drag, with the second possibly creating a financial crisis. Under those circumstances, the best thing for the FOMC to do was nothing.
Committee Decisions Usually Based On Consensus
Back to my committee experience — I found there is psychological need for most committee members to fit in. Most members go along with the consensus, unless they feel very strongly about an issue. There is often a “crank” who always votes a certain way and therefore his/her opinions are usually dismissed by other committee members. That’s the role I see for Esther George in the FOMC. Since everyone knows her views, her vote probably doesn’t sway other committee members.
Since bank credit committees usually have little impact, and are unlikely to be even known to the general public, members who believe a decision is a mistake, don’t usually feel it their obligation to let others know, or at least if they do, do it in a gentle, behind the scenes way.
Rating committees, however, result in a very public outcome. Since democratic centralism prevails, once a decision is voted on, all members of the rating committee are expected to defend the result in public, even if they were strongly against the rating action.
The FOMC And Rating Committees
In a way, I believe the FOMC is in a position similar to rating committees. Members know that their decisions have real consequences. Even if there is a lively internal debate over the correct policy action, especially by members of the FOMC with more experience at the Fed, FOMC members recognize that for the good of smooth market functioning, decisions should appear to be consensual. I would argue that’s why we usually get large majorities for whatever is being voted on. Except for the predictable cranks, most members realize that their vote counts, not only in terms of the actual action taken, but also in appearance to the outside world.
It is for this reason that I take Bullard’s statements to be especially significant. His previous public statements about the risk posed by deflation are still valid. Therefore, given that nothing has changed much on the inflation front, although Bullard probably wants no start to tapering for a considerable period of time, he likely got the strong sense that tapering was the preferred outcome by most FOMC members.
How did Bullard signal that? He started to speak about tapering being possible even as early as October. I guess he is preparing people who follow his public statements closely for a possible vote even possibly by him to end tapering sooner than past public statements might have indicated. Why? As a reasonable committee member, he would need to protect the appearance of the consensual nature of Fed decision-making.
When Will Tapering Begin?
Given that the only thing blocking the Fed from moving is Washington and its political antics, what do I think will happen?
The most likely outcome will be for a continuing resolution (CR) to be passed at the last moment. Even if a CR is not passed in time, a government shutdown, assuming it is relatively short, will not have much impact. As I discussed in my last blog, Obama: Just Say No, a government shutdown has happened in the past, and it could easily happen again. The only thing preventing that would be if the Republican leadership recognizes that such a shutdown would be very bad for their party.
The bigger issue is the debt ceiling. Since Obama has made it quite clear that he is not going to bargain over the debt ceiling, we may come down to the wire on that issue which will begin to be felt by mid-October, or just in time for the next FOMC meeting.
My guess is that if the debt ceiling is not raised, despite my arguments in past blogs against the constitutionality of the President using the 14th Amendment to sidestep Congress, I think Obama may be forced to go down that route. The risk to financial markets is just too great. Paraphrasing a famous Supreme Court Justice: The Constitution is not a suicide pact.
What would happen afterwards? The House might try to impeach the President. However, even if House Republicans were dumb enough to do that, it is an absolute given that the Senate would never agree. That’s the President’s ace-in-the-hole.
The Speaker Of The House
Why will all these issues come down to the wire, and may possibly even be breached? The real reason for the CR fight and the debt ceiling fight is about who will be the next Speaker of the House. Boehner knows that his party is playing a losing hand. However, unless he goes along with his radical wing, he may lose the Speakership.
Mitch McConnell’s Primary Fight
Deal making is made even harder by the tight primary battle Mitch McConnell faces for his Senate seat. If McConnell is once again the go-between that brokers a deal, it is possible that he will lose the primary fight to his Tea Party-backed opponent.
With such risks sitting out there, despite the FOMC’s desire to begin tapering sooner rather than later, the timing of tapering will depend on the outcome of a politically volatile October.
If the CR and debt ceiling are resolved without causing a crisis before the next FOMC meting, then tapering may begin then. If these vital political issues still remain outstanding, and/or are resolved in a way that causes market turmoil, then tapering will wait for a later day.
As always, Clear and Candid.