Wall Street Watch: From Fed Surprise to Fiscal Shock?
Business + Economy

Wall Street Watch: From Fed Surprise to Fiscal Shock?

We read the analysts' reports so you don't have to.

iStockphoto/The Fiscal Times

Ben Bernanke and the Federal Open Market Committee may have surprised investors last week by keeping the rate of the Fed’s asset purchases unchanged at $85 billion a month, but not all Wall Street analysts were caught flat-footed by the dovish decision.

Some economists – including those at BNP Paribas, Bank of America Merrill Lynch and IHS Global Insight, along with Ward McCarthy at Jefferies –projected the Fed would stand pat in September, while still allowing for the possibility that it might do what the markets expected and “taper lite” – or reduce its stimulus by about $10 billion a month.

Now that analysts and investors alike have had time to digest the Fed’s decision, and Bernanke’s press conference comments after the announcement, the question is: What does it all mean?

Here’s one answer, from Julia Coronado, Bricklin Dwyer and Laura Rosner at BNP Paribas in a note to clients titled “Keep Calm, Carry On”:

“What has changed? Not much really. The Fed is still set to taper later this year, maybe early 2014. We are still likely heading toward monetary policy normalization over the next few years, whether U.S. GDP growth is 3.0 percent in 2014 as the Fed expects or 2.5 percent as we expect. But investors must look to the data for clues as to how the Fed is likely to proceed. They need to take the Fed at its word that QE is not on a preset course. To that end, the data Thursday provided a little evidence that the economy may be headed in the right direction as weekly jobless claims, the Philly Fed manufacturing index and existing home sales all came in above expectations.”

With a taper off the table for now, investors will stay focused on the incoming data. But they’ll also have to watch Washington, where Fed watchers now expect President Obama to nominate Janet Yellen to replace Bernanke. Of more immediate importance: another battle over funding the government and raising the debt ceiling threatens to turn the clock back to the summer of 2011.

The uncertainty surrounding that fiscal fight and its possible repercussions was one of the factors – along with lingering questions about the labor market and the “tightening of financial conditions” due to higher interest rates – that the Fed cited in delaying a policy change.

The markets, though, have not yet been rattled by this latest round of D.C. brinksmanship or the uncertainty over a continuing resolution (CR) to keep the government running through mid-December. As Jim O’Sullivan of High Frequency Economics writes:

“While some of the confidence indexes have slipped a little, financial markets have not signaled concern yet about either the debt limit or the CR. After the debt-limit saga of 2011 and the fiscal-cliff showdown coming into this year, there is probably a presumption that some kind of last-minute deal will once again be brokered. That is what we are anticipating as well. We continue to believe that policymakers are not irresponsible enough to trigger a default on U.S. obligations. And while a partial government shutdown is possible—if a CR is not passed—a shutdown would probably be very brief. If necessary, Congress will likely keep passing short-term CRs and debt-limit measures until a longer-term agreement is reached.”

The good news: O’Sullivan and others suggest that the fight over funding the federal government and defunding Obamacare will matter less for the economy than it does politically.

“We agree that there is a lot of uncertainty about how the budget process will play out, although from a broad macro perspective the end result is likely to be a clear-cut fading of fiscal drag regardless of what happens in the interim. In round numbers, we continue to expect fiscal drag to fade from around two points on the annualized growth rate in the first half of this year—following the tax hikes in January—to one point in the second half and perhaps half a point in 2014.”

Even a brief government shutdown wouldn’t necessarily derail the economy, writes Robert DiClemente, chief U.S economist of Citigroup:

“Fortunately, in the unlikely event of a partial shutdown, the impact on the broader economy would likely be very modest and temporary as the loss of pay for furloughed public employees would be made up. The more dangerous threat associated with debt default, however, is not one that can be addressed through bond buying and it is highly unusual that Fed officials would center a decision on tapering on this issue. Regardless, it is possible that deliberations could drag on through yearend or even beyond as the recent history of 13 CRs since 2011 illustrates.”

But given the perpetual state of D.C. dysfunction and the political stakes involved, the risks of a shutdown can’t be easily dismissed, notes Paul Ashworth, chief U.S. economist of Capital Economics. “The most likely outcome is that, after a short period of uncertainty that could roil financial markets, a bare bones settlement will be concluded, albeit not until the very last minute as usual,” he writes, before reminding just how hairy things could get:

“Nevertheless, with the centrist House Republicans squaring off against not only the Obama administration and the Senate Democrats, but the more conservative tea-party faction of the Republican party as well, there is still plenty of scope for the negotiations descend into acrimony, triggering a potentially long and costly government shutdown. Failing to raise the debt ceiling in time could also, in theory at least, force the Treasury to default on its debts. Economic forecasting is hard enough, but predicting the outcome of these political squabbles is nigh on impossible.”

That leaves open the possibility that, just as the prospect of a fiscal fight weighed on the Fed policy-setters this month, it could still be weighing on them in December if Congress and the president need to agree on yet another budget extension.

“Even if Congress and the administration manage to strike deals to extend appropriations and raise the debt ceiling, there is a good chance this will need to be re-visited again as soon as mid-December,” Ashworth writes. “That next deadline would only add to the now massive uncertainty regarding whether the Fed will begin its tapering at the mid-December FOMC meeting.”