- The Fed decided to begin tapering its QE-related bond purchases with a reduction of $10 billion; split evenly between Treasuries and mortgage-backed securities.
- In a sign that tapering was already priced in, the stock market surged on the announcement; while bond yields remained quite tame.
- The Fed announced slightly sunnier economic forecasts, suggesting quantitative easing could wind down within a year.
The Federal Reserve announced a tapering of quantitative easing (QE) today. Specifically, the Fed is cutting its monthly bond purchases from $85 billion to $75 billion; taking the first step toward normalizing monetary policy. The drop of $10 billion will be split evenly between Treasury and mortgage-backed securities (MBS) purchases. The Fed also made slight changes to its forward-looking guidance; although there was no official change to the thresholds for either the unemployment rate or inflation. There was only one dissenter on the Federal Open Market Committee (FOMC)- Boston Fed President Rosengren, who did not want to taper yet.
It was not a foregone conclusion that this decision would come today; although as we've been opining, the odds certainly went up given the strong recent payroll report and the recently-announced budget agreement.
Less accelerator, but no brake
I was on CNBC the other day with my friend Dennis Gartman (of The Gartman Letter), and he made an apt analogy to the prospects of tapering by the Fed. A taper from $85 billion to $75 billion is like slowing a car down on the highway from 85 to 75 mph. The Fed has not put its foot on the brake; only slightly lifted its foot off the gas pedal. The market's reaction suggests investors are looking at it this way.
I was recently asked by a reporter whether the stock market's latest action was a sign that it was "giving permission" to the Fed to taper, and I replied in the affirmative. In fact, it's been our view that it was time to "rip the Band-Aid off;" and that a move toward more normal monetary policy is good news for financial markets.
More good news comes via Treasury yields, which had very little movement on the announcement. In fact, what's interesting is the fact that Treasury yields have actually risen during period when the Fed has been buying and fallen when those purchases ended.
Tapering is not tightening
The Fed, at least so far, appears to have done a better job than last summer in anchoring expectations for short-term rates; reinforcing the notion that "tapering is not tightening." Looking at the Fed's economic outlook, there is very little chance it raises short-term rates in 2014; although two voting members believe it would be appropriate. Most of the FOMC (12 members) expect at least one hike by the end of 2015; with three members believing the first increase won't come until 2016.
Before I get to the qualitative analysis, let's start with an analysis of the Fed's statement accompanying today's decision. One key sentence: "The Committee now anticipates, based on its assessment of these factors, 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. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent."
Fed officials now predict the unemployment rate could be as low as 6.3% by the end of 2014, compared with a September projection of 6.4-6.8%. In fact, in general, the Fed's tone was relatively optimistic; removing the reference to downside risks that had been in prior statements: "The Committee sees the risks to the outlook for the economy and the labor market as having become more nearly balanced." The Fed also mentioned less fiscal drag: "Fiscal policy is restraining economic growth, although the extent of restraint may be diminishing."
The Fed also updated its economic projections; with the forecast for 2013 raised slightly due to recently-better economic data. It expects 2013 real gross domestic product (GDP) growth to be 2.2-2.3% vs. 2.0-2.3% prior; the unemployment rate to be 7.0-7.1% this quarter vs. 7.1-7.3% prior; and core inflation to be 1.1-1.2% vs. 1.2-1.3% prior. The Fed only made very minor changes to its 2014 forecasts.
A lesser-discussed rationale for tapering is related to supply and demand. Quite simply, and as detailed by Strategas Research Partners, "the Fed may be running out of fixed income securities to buy…" In 2009, the Fed bought 20% of net Treasury Issuance; in 2010 it dropped to 15%; but in 2011, 2012 and 2013 (to-date), the Fed has bought 72%, 48% and 75%, respectively.
As for the Fed's future plans: "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. However, asset purchases are not on a preset course…"
In the press conference following the release of the statement, Fed Chairman Ben Bernanke suggested that the Fed anticipates similar-sized ($10 billion) reductions in purchases at upcoming meetings. That would suggest a finale to quantitative easing toward the end of 2014, given that there are eight meetings each year. When asked about likely-incoming Chair Janet Yellen's perspective, he mentioned she was fully supportive of the decision to taper.
Today's market reaction may ease some of the consternation of Fed watchers that believe there is no way the Fed can engineer a benign exit from its unprecedented policy easing/unwinding of its near-$4 trillion balance sheet. But history may be instructive. As Schwab's fixed income strategist Kathy Jones has noted in her recent commentary, in the post-World War II era, the Fed's holdings of US securities totaled about 22% of GDP- the same as the current level. In the 1940s and 1950s, the Fed pursued very similar policies to deal with the debt that was incurred during the war. Eventually the Fed's policies were unwound and the balance sheet restored to normal with limited disruptions; including no major uptick in either inflation or interest rates.
© Charles Schwab