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Current Views

July 31, 2013: Where is the Fed Focused?

Thoughts from our Domestic Equity Team

In our view, the winding down of the Federal Reserve’s quantitative easing program (“tapering”) will not happen until the labor market improves, below-trend inflation returns to 2% driven by a pickup in economic growth, and fiscal policy puzzles are solved. But the Fed may rethink its timetable if the economy does not deliver on these expectations.

The Fed has tied many of its plans to the unemployment rate. Chairman Bernanke laid out guideposts in a statement after June’s FOMC meeting for where he expects the rate to be before the Federal Open Markets Committee (FOMC) makes any big changes—about 7% when it ends the bond-buying program and 6.5% when it starts to consider an increase in short-term interest rates. But we think the unemployment rate may not be a good indicator of the labor market’s health. In the past year, this widely-followed measure has fallen from 8.2% to 7.6%, an apparent sign of improvement. However, the rate has fallen in part because people are dropping out of the labor force—the share of adults holding or seeking a job—meaning they are no longer counted as unemployed. Bernanke himself highlighted this concern at his June news conference, saying that the jobless rate is “not exactly representative of the state of the labor market,” and advised that the FOMC would consider other labor market measures in its policy deliberations. The divergent messages of various labor market statistics about unemployment (U3), underemployment (U6) and participation rates are very clear in the chart below: Source: Washingtonpost.com Another thing to consider is that Bernanke’s term ends in January and a new Fed Chair will guide the bank’s expected transition through tapering and into tightening(raising short term interest rates), creating another layer of uncertainty. Overall, the unemployment thresholds that get so much attention in the markets might turn out to be unhelpful guideposts for the Fed’s actions.

Submitted by: Nainesh Shah, CFA

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