The world is still digesting this week’s big news, that the Fed decided to keep up the pace of its monthly bond buying program known as QE, rather than slowing it down (tapering) which is what many had expected.
Prior to Wednesday, the thinking was that the Fed would slow the pace of QE, not because the economy was so hot, but because QE itself was proving to be less and less effective as an economic stimulant. Matthew Boesler wrote a piece earlier this week laying out various non-data reasons why the Fed would give up on QE.
So why did the Fed keep the program? And if QE doesn’t do anything, then why did markets react so violently (a move most clearly seen in rate markets).
This chart from Morgan Stanley really gets at the answer.
It shows the expected path of the Fed Funds rate based on Fed Funds futures. The blue line shows the market-expected path of the Fed Funds rate pre-Fed meeting. The green line is immediately after the Fed bombshell. The implication is clear. By delaying the onset of tapering, the market also assumes that the eventual actual rate hike will be delayed as well. QE is a form of signaling. As long as you’re doing QE, you’re signaling that the eventual first rate hike is a long way off. Talking about ending QE signals that the first rate hike comes sooner.
This is a point also made nicely by Ryan Avent in The Economist today:
When taper talk ramped up in May and June and markets swung on the news, they weren’t reacting solely to expected changes in the Fed’s balance sheet, but to what the Fed was signalling about its views on the appropriate pace of recovery for the economy. Now as it turned out markets over-interpreted the Fed’s talk. And so the Fed found itself needing to adjust market perceptions. The no-taper call was one aspect of that. So were remarks about the importance of the 7% threshold for ending QE (virtually none, it now seems) and the 6.5% threshold for raising interest rates (almost none, so long as inflation doesn’t stray too far above target). So, for that matter, were comments about the labour-force participation rate.
More than the asset purchases themselves, the signal of continuing with asset purchases is a powerful message that low interest rates will continue for a long time.
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