After a week of surprisingly good economic data and the likelihood of another government shutdown approaching zero, the Federal Reserve will likely taper in December if it sticks to the plan it laid out over the summer.
If it does not do so, it will lose the credibility that it built up at its September meeting.
Back in June, Ben Bernanke outlined when the Federal Reserve would begin to reduce its asset purchases. The chairman specifically emphasized that the taper was not guaranteed. It would all depend on the incoming data. Here's the June FOMC statement:
The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.
Unfortunately, Fed watchers and the market didn't listen to what the central bank was saying. Interest rates on the 10-year Treasury flew upwards while stocks plummeted. Everyone thought that a taper was certain.
This trend continued over the summer as rates rose, but a funny thing happened in September: the Fed didn't taper. This shocked the market and financial analysts alike, but was not particularly surprising given the subpar economic data that had come to light over the previous few months combined with higher mortgage rates and the potential for a government shutdown and debt ceiling fight. The outlook for the labor market had fallen off so the Fed delayed reducing its purchases. This non-taper regained the Fed's credibility as many analysts are now factoring in the economic data when they make their Fed forecasts.
As for the economy, it's almost three months later and the outlook is now above the Fed's June forecast. Thanks to a surprisingly good report last Friday, the last three months have created an average of 202,000 jobs per month. Third quarter GDP came in surprisingly high as well at a 2.8% annualized rate, despite some more worrisome numbers underneath the top line. Mortgage rates have fallen a bit and the possibility of another government shutdown starting in January is increasingly small. The job numbers should be taken with a grain of salt thanks to distortions caused by the government shutdown, but the overall outlook is still positive. The Labor Department estimates that without the shutdown, the unemployment rate would have fallen to 7.0%.
None of this means that the Fed should taper, but if the FOMC wants to retain the credibility it earned this past Fall, it will have no choice but to do so. Bernanke laid out the baseline economic conditions necessary for when the Fed would reduce its asset purchases. Those conditions have now been met. If the November data reverts back to its pre-shutdown trends or below them, then the Fed will reevaluate its actions. But if the numbers come in consistent with what we saw last week, then a Dectaper will likely be in the cards.