The Fed: ‘Tapering’ with care

The Federal Reserve's ‘tapering’ announcement was clearly a success. Going forward, we expect the Fed to cease purchasing assets sometime in the autumn of 2014 and anticipate that the first rate hike will probably occur by around mid-2015.

It was becoming increasingly clear that the Fed wanted to make a start soon on scaling back its purchases of assets under QE3 but, in parallel, it wished to convince all and sundry that tapering does not equate to monetary tightening. With these objectives in mind, yesterday’s ‘tapering’ announcement was clearly a success.

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Modest ‘tapering’ and slow phasing out
The FOMC announced that, beginning in January 2015, the monthly pace of asset buying would be cut modestly from $85bn to $75bn. Regarding future tapering, Ben Bernanke suggested that the FOMC would continue to make a similar reduction, probably at each meeting. However, he also emphasised that the path of future tapering will be data-dependent, and that if the economy slows they could skip a meeting or two. Nevertheless, if our economic scenario of robust growth and slowly rising inflation next year proves correct, the path for tapering will probably be close to the one depicted by Ben Bernanke. Therefore, our main scenario is that the monthly pace of buying will be cut by $10bn at each FOMC meeting in 2014 (see chart above). This means that the asset purchase program will end in October and will total $450bn in 2014, despite the tapering. This remains quite substantial: three quarters of the size of QE2 and almost half of what was purchased in 2013 ($1,000bn).

Strengthened forward guidance
Most forecasters, including us, were expecting the tightening signalled by a first tapering move to be partly compensated by some reinforcement of forward guidance. This is what happened yesterday. The FOMC did not formally reduce the unemployment rate threshold for a first rate hike, which remains at 6.5%. However, in the statement it was added that “it will likely 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 kind of formulation is actually pretty close from a formal cut of the threshold.

Short-term rates projections also reinforcing forward guidance
As usually at the end of the quarter, the Fed updated its set of projections. GDP growth and inflation forecasts were only modified marginally. Unemployment projections were reduced significantly, but that was widely expected following the surprisingly marked decline recorded over the past few months. Nevertheless, the most important point was the revisions to the FOMC participants’ view on the “appropriate pace of policy firming”. Compared to the numbers published in September, the median projection for the target Fed funds rate at end-2015 was reduced from 1.0% to 0.75% and the one for end-2016 from 2.0% to 1.75%. And Ben Bernanke commented on these different projections by saying that they indicated a start to rate hikes in “late 2015”. In short, updated short-rate projections also contributed significantly to enhancing the forward guidance.

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Dovish market pricing of the timing of the first rate hike
The end result was that despite tapering occurring somewhat ahead of most expectations, market pricing of the future path of Fed funds rates has actually turned more dovish over the past two days (see chart above). The first rate hike is now expected by around September 2015. Back at the start of last September, it was priced in almost a year before. This sharp movement shows how successful the Fed has been recently at convincing markets that tapering did not imply a more imminent onset of the first hike in short-term interest rates. On our side, our forecast that the first rate hike will likely occur around mid-2015 remains unchanged. Actually, this forecast has remained unchanged throughout 2013.

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Data dependency
Yesterday’s tapering announcement was very well received in financial markets, most probably because (1) the $10bn trimming was very modest and future tapering moves are supposed to be very gradual, (2) forward guidance was credibly enhanced, but also because (3) the rather early tapering move was correctly perceived as being linked to a noticeable improvement in the economic outlook.

At this stage, it is worth repeating that the FOMC remains completely ‘data-dependent’ and that there is no preset path for the end of QE or the normalisation in short-term rates. Even though it may generate more volatility in the markets and pose some risks to the central bank’s credibility, forward guidance is probably quite useful in helping to push long-term rates down. However, there is absolutely no guarantee that monetary policy will follow the described path.

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Conclusions
Regarding next year and 2015, our monetary policy forecasts are actually basically unchanged. We continue to expect the Fed to cease purchasing assets sometime in the autumn of 2014 and anticipate that the first rate hike will probably occur by around mid-2015. However, one important point is that these forecasts are highly dependent on our relatively bullish growth scenario. Nevertheless, overall, the Fed is likely to pursue a very softly-softly approach to tapering, punctuating the process with dovish comments and signals in its endeavours to stress it is still being quite accommodating. It will do its utmost to prevent its exit strategy from causing an unwarranted too steep spike in long-bond yields. As a result, the adverse impact from scaling back purchases of bonds on financial markets should be limited…

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