by Calculated Risk on 7/05/2013 04:26:00 PM

A few excerpts from a research note by Ethan Harris and Michelle Meyer:

Fed officials must be scratching their heads in regards to the sharp reaction of markets to recent tapering talk. Every “core” member of the Committee has been saying tapering is data dependent: this assumes signs of a pick up in both growth and inflation.

In our view, both the markets and economists have not internalized the Fed’s reaction function. Even before the recent downward revisions, most economists surveyed by Bloomberg had weaker growth forecasts for this year than the Fed and yet more than half say tapering starts in September. ...

Why does data seem to matter so much to the Fed, but not to Fed forecasters? We think the Fed has convinced many forecasters that September tapering is a done deal. In May, Bernanke testified that the Fed could taper “in the next few meetings”; that is, by September. Then at his post-FOMC press conference he said he was “deputized” to lay out a specific exit plan: if our forecast is correct, he said, we will taper later this year and end QE by the middle of next year with an unemployment rate of 7%. In our view, he was describing a sensible reaction that will only be realized if their forecast is correct. By contrast, the market interpretation seems to be: “if they are being this specific and not offering any alternative paths, they must be fairly determined to start tapering.” ...

But we disagree with the market interpretation. Data dependent means data dependent. ...

Although the Fed has attempted to clarify its reaction function, we have become increasingly uncertain. The FOMC has zeroed in on the jobs market and to a lesser extent in reduced downside risks: both argue strongly for near-term tapering. However, the Fed’s mandate is to manage the overall economy and the gap between solid jobs and weakness in other growth and inflation indicators has gotten very big ...

Three scenarios seem plausible. (1) The rest of the economy quickly converges to the employment data and the Fed starts a steady move to the exit in September. (2) The Fed decides reduced downside risks make the case for a one-time dial down in QE, so they taper in September but then pause for an extended period waiting for clear broad-based improvement. In other words, subsequent moves are more data dependent than the first. (3) The Fed decides to wait for broad confirmation in data and doesn’t start tapering until December. The third option remains our base case, but clearly we are out of the consensus and September tapering is increasingly possible.

CR Note: My view is also that data dependent means data dependent. In the two plus weeks since the last FOMC meeting, the data has been below the Fed forecasts (see previous post). I think it will take a clear pickup in the economy during July and August for the FOMC to begin to taper in September; however the consensus is that September is a done deal. Maybe ... perhaps we will know more following the release of the June FOMC meeting minutes next week, and from Bernanke's speech next Wednesday.