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Why the Fed won't taper in December: Goldman Sachs

Ben Bernanke, Chairman of the U.S. Federal Reserve
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Ben Bernanke, Chairman of the U.S. Federal Reserve

The Federal Reserve faces a tough decision at its meeting this week as an improving economy builds the case for the winding down of monetary stimulus, but Goldman Sachs says the central bank is likely to hold off from tapering its $85 billion monthly bond-buying program until next year.

"The case for tapering on the basis of the data since October is mixed at best. The strongest argument in favor is the improvement in the trend rate of payroll growth to the 200,000 level," Goldman Sachs economists wrote in a note late Friday. "However, we expect that Fed officials will also put considerable weight on inflation, which has fallen further in recent months."

The U.S. economy added a better-than-expected 203,000 jobs in November, and the unemployment rate dropped to a five-year low of 7 percent.

However, the Fed's preferred personal consumption expenditures (PCE) inflation measure is near historical low levels, and below the central bank's 2 percent target. Headline PCE inflation eased to 0.74 percent year-on-year in October, from 0.95 percent in the previous month.

"At current spot and projected inflation rates, a tightening move would be quite unusual by historical standards," Goldman Sachs analysts added, noting that their central forecast is for the Fed to begin tapering in March, starting with a $10 billion reduction in the pace of Treasury purchases.

(Read more: Gold is just the tip of the 'Taper Tantrum'

The Federal Open Market Committee (FOMC) will hold its final policy meeting of the year on December 17-18. The meeting will also be Ben Bernanke's second-to-last meeting at the helm of the central bank.

Anticipation is running high as the recent economic data roughly meet the Fed's "substantial improvement in the outlook for the labor market" criterion for tapering the pace of asset purchases, say analysts.

However, Goldman economists says the second reason the central bank will refrain from tapering, is that Fed officials will likely want to offset the first taper with a strengthening of its forward guidance, but probably have yet to agree on the future course of its policies.

(Read more: Fed's dreaded 'taper' may not hurt after all)

"With the unemployment rate now only 50 basis points from the threshold for keeping the funds rate near zero, modifying the forward guidance has become a more pressing priority," they said. The Fed has said that interest rates would remain near zero until unemployment fell to at least 6.5 percent.

"But the October minutes and recent commentary from Fed officials suggests little consensus on how to modify the forward guidance," they added.

The final argument against a December taper is that it would come as a hawkish surprise to markets – a signal Fed officials would not want to send.

"December remains a minority view…it could spark a further tightening of financial conditions. With mortgage rates and the 10-year yield up 30 basis points since the October meeting, this risk is probably unwelcome," economists at the bank said.

(Read more: Dollar bulls bet onmini-taper this week)

According to a recent survey of 66 economists by Thompson Reuters, 32 expected the central bank to act in March, while 22 said it would scale back its bond-buying program in January. Only 12 economists anticipated action this week.

—By CNBC's Ansuya Harjani; Follow her on Twitter: @Ansuya_H

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