Fed to taper ‘later this year‘

by: Peter de Bruin

Fed upgrades assessment of economy, while seeing less downside risks,…

In the press statement released immediately after the meeting, the Fed became somewhat more optimistic about the economy. Although FOMC members still thought that economic activity had been ‘expanding at a moderate pace’, labour market conditions had shown ‘further improvement’ in recent months. This compares to the previous statement where labour market conditions had shown ‘some improvement’. Meanwhile, FOMC members thought that the downside risks to the outlook for the economy and the labour market had ‘diminished since the fall’, whereas previously the Committee saw ‘downside risks’ to the economic outlook.

…and a stronger labour market recovery,…

The more positive stance on the economy was mirrored in the economic projections of FOMC members. Granted, FOMC members did not make big changes to their GDP forecasts, but they did saw a faster labour market recovery, with the unemployment rate falling to 7.3% in 2013Q4 (was 7.4% in March) and 6.7% in 2014Q4 (was 6.9% during the March meeting). All this suggests that FOMC members have become more convinced that the economic recovery is on a solid footing.

…paving the way for a tapering ‘later this year’

Indeed, in the press conference after the meeting, Chairman Bernanke made it very clear that if the economy continues to improve ‘as the outlook suggests’ it will be appropriate to moderate the monthly pace of purchases ‘later this year’. Bernanke stressed though that a reduction in the Fed’s QE programmes would not automatically lead to an imminent termination of the asset purchase programmes. Instead, the Fed was likely to continue to reduce its programmes with ‘measured steps’ through the first half of next year, with the programmes eventually being completely wound down around the middle of next year. At that time, the unemployment rate was seen at around 7%. Still, the Chairman on several occasions during the press conference emphasized that this process would continue to depend on the evolvement of the data and the outlook and was in no way ‘predetermined’.

First rate hike still some way off

Moreover, Bernanke stated that a reduction in the Fed’s asset purchase programmes should not be mistaken for a tightening of policy, as a slower pace of purchases would still have the effect of increasing the Fed’s balance sheet. Indeed, a tightening of monetary policy would only occur when the central bank decides to hike rates. According to the projections of Federal Reserve board members and Federal Reserve bank presidents, out of the 19 meeting participants, 15 saw the timing of the first rate hike in 2015 or later, suggesting that there will be a considerable time between the end of the Fed’s QE programmes and the start of the tightening cycle.

Risks towards earlier Fed move

Overall, both the statement and the press conference were somewhat more hawkish than what we had expected. We continue to think that the Fed will start to reduce its asset purchases in December, though the risks are clearly tilted towards a September move. Still, the process of winding down the Fed’s QE programmes is likely to involve multiple steps and will take until the middle of next year, as we had been expecting. We also remain confident that we will not see the first rate hike before 2015Q1.