Taper caper

The biggest question in the minds of financial market participants now is, "when will the Fed (and the ECB and Bank of England) start to "taper" the extraordinary monetary policy accommodation that we've grown used to over the past half decade?  The Fed statement after this week's meeting gave no explicit clues, but it's clear they're thinking hard about it, and probably won't wait much longer.

The recent data flow in the US has been generally positive, though hardly robust.  Estimates of GDP growth in Q2 were higher than expected, despite the effects of the spending sequester.  Moreover, extensive revisions show that the recession a few years back was less severe than originally thought, and the subsequent recovery just slightly faster.  One implication of this is that there may be a bit less slack in the economy than policymakers had assumed, which has implications for inflation risks.  House prices are rising at the fastest rate since before the bubble burst in 2007.

Against this background, the Fed's key commitment is this:  When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.

Most market participants continue to assume that the "taper" process will begin in September.  The Fed's statement leaves no room for doubt that it will act cautiously, at least at the outset.  This seems to have calmed equity markets, which reacted very badly when the Fed first began to muse about removing stimulus, back in May.  The resilience of equity markets will make it easier for the Fed to "sell" the switch to a less stimulative stance, once it decides to make its move.

One element of the Fed's rhetoric still gives rise to a slight queasiness.  Its concerns over inflation continue to be more focused on the risks posed by it being too low, rather than the threat of it suddenly moving higher. For many years the Greenspan Fed was complacent about inflation, and willing to persist with accommodative monetary policy, while ignoring the disastrous build-up in mispriced risk in the financial system that its cheap money creation had spawned. Given the lack of any real progress in improving financial market regulation and the lack of any apparent contrition on the part of bankers, the risk of another bout of financial instability needs to be taken seriously by the Fed.

Meanwhile, across the Atlantic, both the Bank of England and the ECB have kept rates unchanged yet again.  However, there are growing signs that the UK economy is rapidly gaining momentum -- see this almost breathless story for the latest evidence.  And there's even hope for the beleaguered Eurozone, with improvements reported in employment, manufacturing output and business sentiment.  If the Fed does indeed start to change course in September, others may not be too far behind.