Ever since the topic of stimulus tapering was aired in June, the Fed has hastened to clarify its message: We'll taper if and only if the data argues for tapering. Generally unimpressed with the U.S. recovery since then, the tough talk on tapering has noticeably cooled.
The gradual reduction of the Fed's bond-buying program is not the only stimulus-slowing measure that the Fed may expect to put on extended hold. Interest-rate increases, which the Fed has stated could begin once unemployment reaches the threshold of 6.5%, will be contingent on other factors as well. "Additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments," the Fed has stated, could also play critical roles in determining the course of future Fed policy.
Consensus gives way to uncertainty With its emphasis on contingency at both its mid-September and late-October meetings, the Fed has destabilized the market's ability to form consensus policy expectations and turned the market back on what the data can tell us about how the economy is doing. In our view, this makes for a continuing regime of rate volatility driven by real-time economic releases.
Misreading labor participation a rising problem for policymakers The Fed and market observers, of course, may read the data differently, which makes it doubly hard to know when and how quickly policy may change. Reading between the lines of Fed statements, we believe the Fed may be interpreting U.S. employment data in such a way that it will be inclined to keep policy highly accommodative for longer. According to our analysis of labor-related data, however, we think the Fed could reverse its rate policy more quickly than it suggests. In particular, we read the data on labor participation - which is intimately tied to the unemployment rate and GDP growth - as the potential catalyst for a wage-inflation surprise that could lead to a rapid tightening of policy ahead of the Fed's current guidance.
Read the full story in Putnam's fourth-quarter Fixed Income Outlook.