On Wednesday in the US, the Federal Reserve will conclude its two-day Federal Open Market Committee (FOMC) meeting. And at 2:00 p.m. ET (4am on Australia’s eastern seaboard), it will publish its statement, which will update information on the Fed’s plans for monetary policy.
Everyone expects the Fed to keep its benchmark interest rate unchanged at near-0% (officially 0 to 0.25%)
But more importantly, most economists expect the Fed to finally announce that it is tapering its large-scale asset purchase program, which is informally known as quantitative easing (QE).
QE consists of the monthly purchase of $US45 billion worth of Treasury bonds and $US40 billion worth of mortgage bonds (MBS). All of this has been intended to keep interest rates low to stimulate the economy.
And most economists expect the Fed to begin tapering it.
First, Remember What The Fed Said
Federal Reserve Chairman Ben Bernanke began talking about tapering QE in late May. But the markets didn’t really take him seriously until the June 19 FOMC press conference, which is when he presented a hypothetical roadmap for tapering QE to zero. From the transcript:
…Going forward, the economic outcomes that the Committee sees as most likely involve continuing gains in labour markets, supported by moderate growth that picks up over the next several quarters as the near-term restraint from fiscal policy and other headwinds diminishes. We also see inflation moving back toward our 2 per cent objective over time. If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year; and if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 per cent, with solid economic growth supporting further job gains, a substantial improvement from the 8.1 per cent unemployment rate that prevailed when the Committee announced this program.
Most economists agree that we are on this track.
What Will The Taper Look Like
Ever since the Fed began signalling the taper could come in the Fall, economists have generally estimated that the size of the initial taper would be around $US15 billion (i.e. reducing Treasury purchases by $US10 billion and mortgage purchases by $US5 billion).
However, with economic data falling short of expectations in recent weeks, many economists have reduced their initial taper estimates to between $US5 billion and $US10 billion total. (This is why we’ve been hearing a lot about “taper-light,” “token taper,” and “soft taper.”)
Here’s a round-up of some taper expectations from Wall Street’s top economists:
- Jan Hatzius, Goldman Sachs: $US10 billion all in Treasuries
- Vincent Reinhart, Morgan Stanley: $US10 billion all in Treasuries
- Aneta Markowska, Societe Generale: $US10 billion all in Treasuries
- Drew Matus, UBS: $US7 billion in Treasuries, $US3 billion in MBS
- Joseph LaVorgna, Deutsche Bank: $US10 billion in Treasuries, $US5 billion in MBS
- Michael Feroli, JP Morgan: $US10 billion in Treasuries, $US5 billion in MBS
- Neal Soss, Credit Suisse: $US10 billion in Treasuries, $US10 billion in MBS
- Michael Hanson, BAML: $US10-$15 billion total, split evenly between Treasuries and MBS
- Michael Gapen, Barclays: $US15 billion total, split between Treasuries and MBS
“Regarding the composition of the taper, we assume that the Fed will taper both Treasury and agency MBS purchases,” said Gapen. “Many on the committee believe MBS purchases are more beneficial than Treasury purchases, and a paper delivered at the 2013 Economic Symposium at Jackson Hole, WY, also reflects this view.”
Why They MUST Taper Now
Most economists don’t feel 100% confident that the economic data alone is robust enough to justify tapering QE already. Some have explicitly pointed to non-economic reasons why the Fed will taper.
One such reason is because volatility in the markets, the economy, and especially Washington D.C. is currently low and is likely to rise in coming weeks. Here’s Credit Suisse’s Soss:
…The reason is the calendar. If FOMC policymakers don’t begin tapering this month, the next opportunities are their October 29-30 and December 17-18 FOMC meetings.
October is likely to be right in the middle of the debt ceiling fight. In general, people think these fights will end without tearing the fabric apart, but then again, nearly everyone expects a heightened degree of contention and disharmony. Also, President Obama may announce a nominee for Bernanke’s successor in mid-to-late October. This would not be an ideal moment for the central bank to experiment with a potentially disruptive operational change.
The next opportunity after that is the December FOMC meeting. With only minor exceptions, Ben Bernanke has been on a one-way easing street for over six years, beginning back in the summer of 2007. Does he really want his last holiday present to the nation and world economies to be a potentially negative shock?
Still, not everyone agrees we’ll hear about the taper on Wednesday.
Why They Might Taper Later: The Economic Forecasts
Bank of America Merrill Lynch’s Michael Hanson is one of the very few economists who’s betting the taper won’t be announced on Wednesday.
“We see a very close call, with a higher probability of tapering later this year (our base case is December) than at the September meeting,” said Bank of America Merrill Lynch’s Michael Hanson.
“While we expect the Fed to taper at one of the next three FOMC meetings, we see good reasons to be patient: recent data have, on balance, underperformed; the Fed needs to reduce its over-optimistic forecasts; and downside risks have re-emerged.”
When the Fed publishes its FOMC statement, it will also update its economic forecasts (which Hanson mentioned above). Almost everyone expects the Fed’s numbers to be revised downward.
What If Tapering QE Was A Mistake?
There’s always the risk that interest rates begin to rise at a rate that puts the U.S. economic recovery at risk again.
But the Fed still has “heavy-calibre ammunition in reserve” for such a scenario. Here’s Morgan Stanley’s Reinhart:
…True, Fed officials have used QE in the past to signal the Fed’s willingness to keep policy accommodative for a considerable period. But that was then. Now they can signal the intent to keep policy accommodative — the forward guidance so much in vogue among central bankers — by adjusting their threshold on unemployment or introducing a lower bound on inflation. With this heavy-calibre ammunition in reserve in the event yields back up uncomfortably later in the year, they can put QE on the road to retirement. For the incumbents at the Fed, starting now puts a body in motion that will stay in motion for the next leader.
Regarding “forward guidance,” the Fed employs an unemployment rate threshold of 6.5% and an inflation rate threshold of 2.5% to help guide monetary policy. In other words, as long as unemployment stays high and prices remain low, the Fed will continue to do what it can to keep rates low.
About Forward Guidance
Some economists believe the Fed could make an adjustment to its forward guidance on Wednesday. The Fed could conceivably offer a lower bound to its inflation rate threshold (e.g. not raising its benchmark rate as long as the inflation rate is below 1.5%).
It could possibly enhance its unemployment rate threshold by adding other qualifiers.
“One option… is to qualify the 6.5% unemployment rate threshold with participation rate or employment- to-population ratio variables,” said JP Morgan’s Feroli.
However, Feroli warns that it could be dangerous to adjust the unemployment rate threshold itself. Here’s Feroli:
We think this is inadvisable, and we don’t think the Committee will choose this option. While lowering the unemployment threshold would push back market expectations of the first rate hike, it also comes with some problems. First, as mentioned in the last minutes, it risks creating the impression that the threshold can be adjusted up, as well as down, which would defeat the whole purpose of the threshold as a form of commitment. Second, six Committee participants believe the natural unemployment rate is 5.8% or higher. These participants would likely view lowering the threshold as particularly risky, and would likely increase the number of dissents. Thresholds are only an effective communication device when they are viewed by the public as representing a committee consensus, thus more dissents could actually make this move counter-productive, particularly at a time when prospective Committee turnover is quite high. Third, lowering the threshold would provide additional easing, rather than merely reinforce communications regarding existing policy. Easing and reducing easing (through tapering) at the same meeting makes sense if the Fed explicitly admits that their thinking on asset purchases was faulty — and the Fed rarely likes to admit their previous thinking may have been flawed. Finally, lowering the threshold does nothing to address what the FOMC is seeing as the emerging communication challenge: guiding expectations for the path of policy rates after the point of lift-off.
Feroli echoes a concern that the Fed knows about. From the July 30-31 FOMC Minutes:
…In general, there was support for maintaining the current numerical thresholds in the forward guidance. A few participants expressed concern that a decision to lower the unemployment threshold could potentially lead the public to view the unemployment threshold as a policy variable that could not only be moved down but also up, thereby calling into question the credibility of the thresholds and undermining their effectiveness. Nonetheless, several participants were willing to contemplate lowering the unemployment threshold if additional accommodation were to become necessary or if the Committee wanted to adjust the mix of policy tools used to provide the appropriate level of accommodation….
Any mention of forward guidance will likely come during the Fed’s press conference at 2:30 p.m. ET.
For More On The FOMC Announcement And The Taper:
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