Fed Moves Forward on the Taper, but Don’t Assume It’s a One-Way Street

On Wednesday, the Federal Reserve recognized the fundamental improvements in the U.S. economy and announced that, in January, it would begin paring back its bond-buying program by US$10 billion per month. This is the “taper” that everyone’s been talking about. The Fed had their first window at tapering back in September, when just the suggestion that tapering was a possibility was enough to send markets shuddering. The Fed’s communication machinery seems to have been more “well-oiled” this time around because both the Dow and the S&P 500 ended Wednesday at record highs. This means that markets are seeing the taper for what it is, a sign that the U.S. economy is on a path of stable growth.

The possible cause of concern is that the market panics if economic data in early 2014 isn’t as rosy as it has been in recent months. With the taper now official, it’s important to understand that tapering isn’t an inevitable one-way street. The Fed has reserved the right to slow, halt, or reverse the taper if economic conditions warrant. In the FOMC statement, the Fed put it this way:

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, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.

I believe that the Fed now has the ability to use the taper as a stabilizing mechanism in 2014. I can easily envisage a scenario where they begin to taper in January, follow up with another reduction in March; then, if the yield on the 10-year Treasury spikes, they could re-accelerate bond purchases to help keep long-term rates under control. The Fed has communicated this kind of thinking over the last few months, but to enact such a strategy, the taper had to happen fairly soon. I think that’s another reason why the Fed announced the taper this week.

One other note, this one on the forward guidance in the FOMC statement. QE has been meant to help control longer-term interest rates, but the Fed also controls short-term rates through the fed funds rate, currently set in a range between 0% and 0.25%. This month, the Fed’s statement was a bit clearer about its intentions on those shorter rates, adding some additional wording:

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.

This marks the first time the Fed has officially acknowledged that it would keep rates low beyond a time when unemployment falls below their target of 6.5%. It signifies that the target is just that – a target, not a trigger. If you’re interested in exactly how the Fed changed their statement, CNBC has a nice marked-up copy that compares December’s statement to October’s. If you missed it, you can also check out my previous blog post on the fundamental underpinnings that laid the groundwork for this week’s taper.

 

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