To Taper Or Not To Taper in September?

Earlier this week, we talked about how the markets have been abuzz on talk that there’s a good chance the Fed will begin scaling back its asset purchases in September.

But how likely is it?

According to PaddyPower’s betting odds, even before the U.S. July retail sales report was released, the odds favored a 36% probability that the central bank would taper its QE program next month. But after seeing the retail sales report show a fourth consecutive month of growth, many have come to believe that the odds have risen even further.

Heck, even the hot shots on Wall Street think so. Primary dealers say that Ben Bernanke will likely announce a cut from its monthly purchases of $85 billion to just $65 billion in September.

Rising treasury yields

The wide-spread belief that the Fed will taper stimulus in September (a.k.a. “Septaper”) is already reflecting itself in the markets and causing U.S. Treasury yields to rise. Market watchers now fear that the prospect of tapering could push yields to spiral out of control.

However, Goldman Sachs thinks the Fed could counteract the upward push of tapering on yields by providing the markets with forward guidance on the Fed funds rate, which is still at near-zero levels.

Remember, the Fed has said in the past that it will only consider raising interest rates if unemployment falls below 6.5% and inflation reaches 2.5%. Goldman Sachs believes the central bank might change its language to ensure investors that these low rates are here to stay and keep the financial markets stable.

There are two ways the central bank can do this.

First is for the Fed to lower its unemployment rate target, which currently stands at 6.5%.

Second, the Fed may opt to tie its unemployment target to the inflation rate or labor force participation. For instance, it could say that it will lower its unemployment threshold if inflation falls below 2% or the participation rate continues to deteriorate.

FOMC officials on tapering

Some FOMC officials haven’t been shy about their support for tapering, which suggests that it may come sooner than later. In fact, when asked about Septaper, Chicago Fed President Charles Evans said he “would not rule out” such a move, which is similar to remarks Cleveland Fed President Sandra Pianalto and Dallas Fed President Richard Fisher have made.

Even Atlanta Fed President Dennis Lockhart, who has been a strong supporter of the Fed’s QE program, has said that the central bank may begin slashing stimulus next month.

Deciding factor?

So now it seems as though everyone and his mother is expecting Septaper. But of course, it’s all still just speculation. What may seal the deal is the August non-farm payrolls report.

In last month’s jobs report, we got disappointing news as we saw an increase of just 162,000 jobs (versus 184,000 forecasts). If this month’s numbers fail to meet expectations or fall below July’s figures, it will be hard for the Fed to justify a scaling back of asset purchases.

After all, one month doesn’t make a trend, but two months of week jobs data makes a pretty good argument against winding down stimulus.