Wednesday, December 18, 2013

Things to expect from the FOMC meeting: Why it (should) be time to taper

Breaking the pattern from my usual soccer posts, I decided to put out a couple of interesting thoughts on the Fed's year-end meeting.

There has been a lot of buzz in the market about the Fed's policy to eventually taper its asset purchasing programs (quantitative easing/QE) and unlike what happened in May at the first suggestion of tapering, the Fed is widely expected to outline exactly how it will reduce its purchases so as not to create a severe market panic using forward guidance as a tool.  Janet Yellen, the new Fed chairperson, is widely regarded as an effective communicator, in addition to her longstanding support for tapering.

The last time the Fed had a meeting was in October in the midst of the fiscal cliff debates, so naturally with a downturn in optimism across the nation and uncertainty about the state of the government's finances, the Fed decided to delay its decision to taper; however, with the economy on a stronger upturn than normal (not just fueled by the increase in seasonal unemployment), the Fed could accelerate the process a bit. Here's what we can reasonably expect at this meeting.

  • The Fed will likely not announce that tapering is to start by the end of December or even January. Given the looming sequester cuts in Congress and the uncertainty that it will cause, the Fed would not want to do anything to exacerbate the resulting situation.  
  • Fed officials will outline the specifics of their tapering program. Specifically, they will likely emphasize the reduction in treasury purchases given the inflated state of the bond market.  This will lower demand in the bond-market and raise treasury yields.  They will also stress that they are not immediately cutting out treasury purchases entirely so as to alleviate market uncertainty
  • The Fed will cite that their purchasing strategy will not increase the risk of the balance sheet as purchases of treasuries will be positive along with a continued sustained mortgage backed securities purchase
  • Tapering may be somewhat uneven given the seasonal fluctuations of economic growth in the United States (The past four summers have been characterized by slower growth), but it will definitely be methodical.  
  • The Fed may also address trepidation about the rapid growth in the stock market, given that they have absorbed a lot of risk themselves by adding MBS to their portfolios and that borrowing is still not reaching very rapid levels.  
  • Interest rates will not be altered until the economy shows a sustained recovery with tapering.   
A lot of credit has to go to Ben Bernanke, for his work throughout the crisis.  This was a rather unprecedented situation and many investors and market analysts were critical of the Fed's involvement in the financial market.  But given how interconnected financial markets are with federal assets nowadays, it was necessary for the Fed to use its position as a risk-free lender to balance out an incredibly risky market in the wake of the crisis and stimulate investment and expenditure. I would argue the Fed has had a greater impact throughout the crisis than the government.  The Rescue and Recovery Act stopped the bleeding, but the Fed's policies since 2010-11 have been gradually raising inflation to pre-recession levels and they have reacted quickly to fluctuations in the job market.  

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