Signs point to Fed tapering but questions remain

PHOTO: Signs point to Fed tapering but questions remain

UNITED STATES - The smooth run that financial markets have enjoyed so far in the northern summer may soon draw to a bumpy close.

An increasing number of economists expect the United States to start dialling back its asset-buying programme next month.

The scheme was meant to reinvigorate the US economy but has also helped keep global stock markets flush with cash for many months.

The "taper threat", as investors have dubbed this fear of a US reduction in liquidity, has been looming larger amid strong signs from the American job market.

Jobless claims in the US for the week ended Aug 10 dropped to 320,000, the lowest level since October 2007, before the global financial crisis began.

Economists had tipped that employers would let go of more workers, but were pleasantly surprised when firings fell 15,000 instead.

The overall US unemployment rate has also kept falling, reaching a four-year low of 7.4 per cent in July from 7.6 per cent in June.

Meanwhile, the housing market has rebounded with home prices and builder confidence rising; consumer sentiment and retail sales are also up; and the pace of inflation - while still low - appears to be slowly accelerating.

Taken together, this might be enough evidence to convince the US Federal Reserve that the economy has attained enough momentum to be slowly weaned off its injections of liquidity.

A poll of economists by Bloomberg earlier this month showed that 65 per cent of them expect the Fed to announce tapering of the quantitative easing (QE) policy, as it is known, at its Sept 17-18 meeting, up from just half in a similar survey last month.

But this is by no means a foregone conclusion, said Standard Chartered economists led by Mr Thomas Costerg.

"The signals from both recent data and the Fed's rhetoric are not clear-cut: this is still a close call," they said in a report last Friday.

Some of the remaining question marks hang over US manufacturing, which has failed to sustain a convincing upturn, as well as the quality of the improvement in the job market.

Figures last week showed that factory output was unchanged in July from June, despite advance surveys that had hinted at stronger manufacturing.

Capacity utilisation - a gauge of how much a company makes use of its factories - also edged down last month, defying hopes of a rise, and the Philadelphia Fed manufacturing index posted an unexpectedly large drop in the same month.

Barclays economist Peter Newland said the manufacturing numbers struck "a soft tone" for the start of the third quarter, but were in line with his view that the US economy "may not accelerate as much as some anticipate" in the second half of this year.

Meanwhile, even as unemployment falls, US employees are taking home lower wages and working fewer hours.

More than half the jobs created in July were in the low-paying restaurant and retail sectors, prompting some economists to warn that the job market is far from strong.

Even if the Fed does go ahead with tapering next month, what form it will take is still up in the air, as is the rest of the exit plan from QE.

Most economists now believe the Fed will take baby steps, scaling back its monthly bond purchases by US$10 billion (S$12.7 billion) a month from the current US$85 billion.

This is compared with the US$20 billion reduction they had expected last month. Under this theory, the Fed would end its buying programme altogether by the middle of next year.

"If anything, they may err on the side of tapering less rather than not doing it at all," Mr Millan Mulraine, director of US research at TD Securities, told Bloomberg. "It will be a cautionary first step for extricating the Fed from QE."

Stanchart's Mr Costerg and his team tip the Fed to cut back on buying US Treasuries first and leaving purchases of mortgage-backed securities as is, rather than scaling back both equally.

"We believe data on the labour and housing markets is particularly important for the tapering outlook," they said.

"We think there will be a steady acceleration in growth, which supports a steady tapering path until the second quarter of 2014, when QE is likely to terminate."

A slow and steady withdrawal of QE, and one responsive to unexpected economic deviations, would be best for all involved.

But with US and Asian stock markets already starting to fall last week on tapering expectations, investors had best brace themselves for September's rocky ride.

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