- Fed embarks on the beginning of the end of monetary stimulus, but it will be a long goodbye
- Pace of asset purchases unexpectedly reduced, while further tapering lies ahead…
- …however it also signals that rates will be on hold ‘well past the time’ unemployment hits 6.5%
- Financial markets react positively reflecting enhanced forward guidance
Fed decides to reduce pace of asset purchases
The FOMC decided to reduce the pace of its asset purchases at its December meeting, but also sugar-coated the pill by enhancing its forward guidance. Beginning in January, it will reduce its asset purchases to USD 75bn (made up of USD 35bn mortgage-backed securities and USD 40bn Treasury securities) from USD 85bn currently (USD 40bn MBS and USD 45bn Treasuries). The reduction in asset purchases reflected an improvement in the economy and labour market conditions ‘consistent with growing underlying strength in the broader economy’. It also signalled that ‘if incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings’. In Chairman Ben Bernanke’s press conference, he signalled that in the Fed’s central scenario, asset purchases would end late next year. Given similar steps, the programme will probably be ended by October. Mr Bernanke underlined that these steps would be data dependent, and the Fed would sustain purchases if the economic recovery faltered or inflation failed to moved back towards its goal.
Enhanced forward guidance, rate hikes not until late 2015
Meanwhile, the FOMC changed the wording of its statement to signal that interest rate increases are some way off. Although it kept the unemployment threshold at 6.5%, it reduced its importance in its judgement about when to increase policy rates. The statement asserted that ‘it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal’. This reflects its assessment of other factors apart from the unemployment rate, including other labour market indicators and measures of inflation pressures, that seemed to suggest that later rate hikes would be appropriate. The FOMC reduced its central projection for the unemployment rate to around 6.5% by the end of next year (see chart). Still, it expected the fed funds rate to rise to 0.75% by the end of 2015 (which fits with the first rate increase in September of that year) compared to 1% in the previous set of projections.
The long slow goodbye to super accommodative policy
Overall, the message seems to be that the Fed has embarked on the beginning of the end of exceptional monetary stimulus, but policy will remain accommodative for a very long time, so it will be a long, slow, goodbye. Our central scenario is similar to that of the Fed with regards to tapering of asset purchases, with QE ending in autumn of next year. However, we expect rate hikes to start a little earlier (mid 2015), given our relatively more upbeat expectations for the economy and the labour market.
Markets react positively to sugar-coated taper
Financial markets in the end reacted relatively positively to the FOMC statement. The initial reaction was one US dollar strength, lower US equities, a rise in 10-Y Treasury yields and lower gold prices as financial markets focused on the reduction of asset purchases. Soon afterwards, these moves partly reversed as the market digested the enhanced forward guidance (and perhaps the increased confidence in the economy) in the statement. Indeed, equity markets were significantly higher at time of writing, while Treasury yields were close to the levels seen before the FOMC statement. However, the dollar remained stronger, while gold prices fell. During the course of next year, we think Fed tapering and positive investor sentiment will go hand in hand. We expect Treasury yields to rise, but only moderately, while dollar strength and gold price declines are likely to be key trends.