Will Congress Cause the Taper?

Something may happen on December 31^st that could erroneously cause the unemployment rate to drop substantially almost overnight.

If it does, some fear, it could force the Federal Reserve to cut its monthly bond purchases immediately, and it might also speed up the raising of interest rates much sooner than the markets expect – killing the recovery, sending equity and bond markets into freefall, and perhaps even plunging the nation into another recession.

What is that event that could potentially force the Fed to act sooner than expected? The expiration of unemployment benefits at the end of this year, which could cause the unemployment rate to drop from the current 7% to well below the Federal Reserve’s 6.5% target. Many fear that once the jobless rate crosses below that ominous 6.5% threshold, accommodative policy could end, and the recovery along with it.

The debate over extending benefits is now on in Congress, with those looking to cut government expenses leaning on the side of expiration, while those looking to keep stimulating the economy leaning on the side of extension.

Funny Accounting Could Move the Fed

But before we can understand what the debate in Congress is all about, we need to take a look at how the Federal Reserve tabulates the unemployment rate. Very simply put, if an unemployed person has been actively looking for work over the past 30 days, he or she is added to the number of unemployed and factored into the unemployment percentage rate.

But if the unemployed individual has not looked for work for more than 30 days, they are tossed into a different bin labeled “marginally attached workers”. They are considered on the margin or fringe of the work force, are not counted in with the job-seeking unemployed, and are thus not factored into the unemployment rate, even though they really are unemployed.

Separating the unemployed into two groups – counting one group and leaving the other group out – is a clever way of making the unemployment rate look better than it really is. If we counted all unemployed from both groups the true unemployment rate would be much higher – closer to 9%. But as it is, the official number is 7%.

Yet that rate could drop substantially if unemployment benefits are not renewed come January 1^st. The skills of the recipients “have deteriorated to such an extent that they are not employable,” Jeffrey Rosen, chief economist for Briefing.com writes as cited by Yahoo! Finance. “Once the unemployment benefits end, there will be nothing to connect these long-term unemployed to the labor force.”

The cut in benefits would cause some ex-recipients to go back to school, others to wake up and get a job fast, and yet others to give up and stop looking altogether. These reactions would lower the number of “official” unemployed and in turn lower the unemployment rate.

Should that rate fall to 6.5% or below (which has long been the Federal Reserve’s target), many fear the Federal Reserve would cut its monthly bond purchases far too abruptly and raise interest rates far too prematurely.

They fear the underlying economy is not yet strong enough to sustain itself without continued support from the Fed. So once again, the fate of the economic recovery rests in the hands of Congress and a single decision. And once again the markets gyrate nervously.

The Debate

Here’s what the two sides of Congress are debating…

Renewing the benefits puts more money into the hands of the unemployed, which keeps them spending and the economy humming. “Allowing EUC [Emergency Unemployment Compensation program] to expire,” a White House report issued Thursday claimed, as transcribed by USA Today, “would be harmful to millions of workers and their families, counterproductive to the economic recovery, and unprecedented in the context of previous extensions to earlier unemployment insurance programs.”

A renewal would further stimulate the economic recovery by keeping the Federal Reserve’s easy money policies in place longer, as the unemployment rate would remain higher.

However, renewing benefits for another year would incur additional government expense, requiring more borrowing and a higher debt ceiling increase. Letting benefits expire would not only reduce government spending but would also help focus efforts in areas considered more supportive of the recovery.

“The president’s real focus,” Republican House Speaker John Boehner declared to reporters as quoted by Bloomberg, “ought to be creating a better environment for our economy and creating more jobs for the American people. Not more government programs.”

Expiration would also urge many current recipients to step up their efforts to find work or take measures to retrain and improve their eligibility for work, possibly helping fill a current shortage for workers in skilled trades. Remember that not all job categories lack employment opportunities. Some job sectors have plenty of work available but lack qualified workers.

However, allowing benefits to expire would lower the unemployment rate, which brings us back to Fed tapering and higher interest rates…

Or does it?

Fears Unfounded

The fear that a drop in the unemployment rate to or below 6.5% would prompt the Federal Reserve to slash its monthly bond purchases and start raising interest rates is really quite misguided.

The monthly bond purchasing program is not linked to that magic 6.5% number. Although the Fed will take “the outlook for the labor market” into account when determining whether to continue or terminate the monthly bond purchases, these “asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s economic outlook as well as its assessment of the likely efficacy and costs of such purchases,” the Fed stressed in its last press release.

It is the raising of the benchmark interest rate that is linked to a 6.5% jobless rate – yet only loosely so. Fed Chairman Ben Bernanke has repeatedly assured the markets that the rate is merely a threshold, not a trigger.

In fact, the minutes of the last FOMC meeting of late October show that the Committee members are rather concerned over the markets’ clinging to that 6.5% number, noting that the FOMC members “examined several possibilities for clarifying” their position on interest rates.

“A couple of participants favored simply reducing the 6-1/2 percent unemployment rate threshold,” the minutes revealed. “Participants also weighed the merits of stating that, even after the unemployment rate dropped below 6-1/2 percent, the target for the federal funds rate would not be raised so long as the inflation rate was projected to run below a given level.” As a third option, the members considered stating “that even after the first increase in the federal funds rate target, the Committee anticipated keeping the rate below its longer-run equilibrium value for some time.”

Do we get the picture they are trying to project? The Fed wants the markets to just relax over that 6.5% number. In the end, the wording they decided to go with was:

“[The Committee] currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent.”

“At least as long” means that even after that 6.5% threshold is reached, interest rates could still remain low for a long, long time. “In determining how long to maintain a highly accommodative stance of monetary policy,” the release added, “the Committee will also consider other information, including … indicators of inflation pressures and inflation expectations, and readings on financial developments.”

It’s not just about the unemployment rate, and investors would do well to refrain from putting too much emphasis on just that one number.

Investor Expectations

Whether or not the special EUC benefits are extended for a 12^th time since President George W. Bush implemented them following the 2001 crisis, there is no reason to expect this congressional policy decision to affect the Fed’s plans to taper monthly purchases or raise interest rates. The Fed has other data to consider in addition to the unemployment rate.

Investors ought to expect tapering on the basis of a sustained improvement in the economy and on robust job creation. We seem to be getting close to such a tapering, perhaps in late Q1 of 2014. Bonds and equities will fall on the news initially – that is pretty much a certainty.

But low interest rates are expected to continue for an extended period, perhaps well into 2016. So any taper-induced correction in stocks should be bought with sights set on continued all-time stock market highs for a few more years to come.

Joseph Cafariello

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