Strengthening economic data has some people arguing that the Fed could begin tapering after the December 17-18 Federal Open Market Committee meeting, but according to Nomura Research Institute chief economist Richard Koo one thing not many people are considering is that tapering needs to start well ahead of policy tightening.
Third-quarter GDP growth has been revised upward from 2.8% to 3.6% (quarter on quarter, annualized), and unemployment is down to 7.0%. “All in all, I think the conditions required for the Fed to start ‘tapering’ QE are falling into place,” writes Koo, adding that “it is important to understand that the tapering now being discussed is different in both name and nature from a standard tightening of monetary policy.”
Tapering will take at least nine months
Even while the Fed is tapering, it will still be buying assets and injecting liquidity into the system, so monetary policy will still be very accommodative. When it comes time to tighten policy, as early as the end of 2014 according to some estimates, the Fed will need to have already completed tapering and begun taking some slack out of the system, which Bernanke has previously said will take at least nine months.
“The fact that financial markets must be brought back to normal—i.e., that the stock of liquidity must be reduced—before any actual tightening can take place is complicating the Fed’s decision. Nor does the central bank have any historical precedent to guide it,” writes Koo.
Koo: Starting tapering now is better for both Bernanke and Yellen
Koo argues that this should give Fed chairman Ben Bernanke further incentive to get tapering started so that no one can criticize him for starting what amounts to a giant monetary experiment without even attempting to wind it down. “As the man responsible for launching quantitative easing, Mr. Bernanke would no doubt like to set a course for the normalization of monetary policy before his term expires,” he writes.
But there must be at least some temptation for Bernanke to leave things as they are and go out on top at the end of January. If he doesn’t, it could be difficult for Fed chair Janet Yellen to start tapering right out of the gate, postponing it until the spring and making it extremely difficult for the Fed to tighten policy by the end of the year. But if Bernanke is thinking about his own legacy first and foremost, that timeline might not even be a factor.