Looking Beyond the Initial Fed Taper

The Fed’s taper announcement might have been its most closely watched announcement of all time. We pretty much knew what was basically going to happen (eventually taper QE, strengthen forward guidance), we just didn’t know exactly when and exactly how much. Now we know.

The Fed will reduce its bond purchases from $85 billion/month to $75 billion/month in January. In the Q&A, Bernanke suggested purchases might be cut another $10 billion at each upcoming FOMC meeting — implying the program would end in late 2014. It also strengthened “forward guidance”, saying it would keep the Fed Funds rate at current levels “well past the time that the unemployment rate declines below 6.5 per cent.”

Immediate market reaction: good news is good news

Long Treasury yields ended the day modestly higher, but there was no sharp sell-off: it’s safe to say that the bond market appears to have largely discounted the Fed’s actions. The movement of shorter-term interest rates suggests that the bond market has accepted what the Fed has been saying: that the QE taper and the (eventual) hiking of the Fed Funds rates are separate decisions. In contrast to the market’s spring/summer reaction to the first hint of a taper, short-term interest rates and Fed Fund futures remained low. The stock market moved much more dramatically than the bond market, with the S&P 500 up 1.7% on the day.

The Fed’s slight upgrade of its economic forecast and the other economic news released yesterday (good housing starts) was not enough to explain the stock market rally, so it seems that the market was pleasantly surprised by the Fed (did it want a taper?) . . . or perhaps there were short positions (bets that the market would decline if a taper were announced) that had to be covered when the market started rallying.

Good news as bad news schizophrenia

That’s the problem when there’s a widely anticipated announcement: with everyone betting on the outcome, the direction and magnitude of the post-announcement market move will be driven more by those bets being paid off than by the news itself. In recent weeks, the stock market has sometimes acted like “good news is bad news,” selling off on good economic news, presumably because it increased the likelihood of a QE taper, and vice versa. On other days, it’s acted like “good news is good news” — that’s what it did Wednesday. If you’re trying to trade the markets, this schizophrenic behavior can make you crazy. It’s easier to stay sane if you take the longer view: the economy is improving and Fed policy is adapting to it.

The interaction of fiscal and monetary policy

The Fed has expressed its strategic view on fiscal policy many times: it has wanted to see less near-term deficit reduction (fiscal austerity) at a time when the economy was emerging from recession, and more progress on longer-term entitlement reform that would keep the government’s debt/GDP ratio down. It’s also wanted to see less brinksmanship and more bipartisanship. Before September, it was not getting what it wanted.

The Fed hasn’t gotten everything it wanted, but the atmosphere in Washington has changed dramatically since September: the government shutdown and debt ceiling standoff persuaded the Republican Party that confrontation wasn’t a winning strategy, and the Democrats, wounded by the Affordable Health Care rollout, were willing to cooperate. The Ryan-Murray accord, which both houses of Congress quickly accepted, is not a grand bargain or breakthrough, but it is a businesslike deal which increases spending slightly in the near term in return for some progress on entitlement reform (government pensions) and deficit reduction.

This change in Congress reduced one of the threats to the economy the Fed was “insuring” against — opening the door for the Fed to taper — and it did so.

Contrasting central bank philosophies: tough love vs. behavior-enabling

I’ve felt that the Fed was engaging in “enabling behavior” — by preventing the “bond vigilantes” from imposing market discipline on the government, the Fed has enabled the government to avoid hard fiscal policy decisions. The European Central Bank (ECB), on the other hand, has engaged in “tough love” — not offering assistance until/unless a government irrevocably commits itself to structural reform . . . and by not buying any government bonds (no QE) under Draghi, despite his promise to do “whatever it takes.” The result is that that the U.S. economy has grown while Europe has suffered an extended recession. European governments, on the other hand, generally have smaller budget deficits than the U.S. even with their economies just bottoming out, and the ECB’s balance sheet is not loaded up with long-duration government bonds. While the U.S. economy is in better shape than the European economy, European governments and the ECB have more “dry powder” available to them than the US government and Fed if future stimulus is needed.

While the Fed’s policy has produced a better outcome in the past two years, the real test will come in the longer term: can the Fed unwind its balance sheet without disrupting markets, stalling the economy, or imposing losses on taxpayers and investors? The Fed still has a lot of hard work in front of it.

Can the Fed be believed or trusted? . . . the tension between data dependency and forward guidance in Fed policy

FOMC statements have always stressed that its decisions are data-dependent: the Fed can change course if the economy changes course. The path of the QE taper can be revisited if the incoming data doesn’t broadly support the FOMC’s forecast of ongoing improvements in the labor market and inflation moving back towards 2 per cent. That data dependency contributed to the FOMC’s surprise decision to defer the start of the taper back in September — they saw the 10-year Treasury rising to 3% (among other things).

An inherent contradiction in language

The problem comes when the Fed seeks to give strong forward guidance: if future policy is data-dependent, its forward guidance on rates is not credible. For its guidance to be credible and non-trivial, it would have to commit to being non-data-dependent when the data-consistent policy conflicts with the guidance. There’s an inherent contradiction. Even as it sought to strengthen guidance in the most recent statement, it left a data-dependent back door: “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 6½ percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.”

If inflation remains low — as expected — the Fed Funds rate is highly likely to remain at current levels through the end of 2014. 15 out of 17 FOMC participants project no change this year. Essentially everyone expects at least one hike in 2015; the median forecast for end-2015 is 0.75%; at end-2016 it’s 1.75%.

On balance, it’s probably better to understand what data the FOMC is looking at and how it will react to that data than it is to take their forward guidance at face value. If inflation remains low, Fed funds will remain low. As we look at the economy, that’s our expectation . . . but, like the Fed, we will be “monitoring inflation developments carefully” for signs of rising inflation. If inflation surprises on the upside, we’d bet that data dependency will trump forward guidance.

Personnel changes and Fed policy

It’s widely known that Bernanke’s term ends in January; it’s widely expected that Janet Yellen will be confirmed as the next chair shortly. One of the questions had been: will Bernanke start the taper on his watch, or will he leave it for Yellen. I’d thought he’d do it — commits the Fed, takes the heat off her — but there were others who believed the opposite. Now we know.

It’s no secret that Yellen is a Keynesian, a dove, and one of the architects of QE, so the baseline forecast is that the Fed will remain accommodative. The new development of the past week is that Stanley Fischer (former head of the Bank of Israel) is apparently President Obama’s choice to replace Janet Yellen as Fed vice-chair. Fischer is a living legend — both Draghi and Bernanke were his students in their youth. His reputation is more hawkish than Yellen’s . . . and the normal rotation of voting authority within the FOMC next year is likely to lead to a generally more hawkish bias. It will be interesting.

The bottom line

I view the Fed move as entirely consistent with an economy that is growing, that no longer needs extraordinary support, that is no longer facing the headwind of fiscal austerity (deficit reduction), and that is no longer threatened by a dysfunctional and paralyzed Congress. The healing process is well underway and we’re starting to move back to normal.

© Pioneer Investments


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