Market outlook

Taper implications beyond Ben Bernanke chairmanship

Source: Tim Evanson

Source: Tim Evanson

Bernanke signs off with taper but implications to be felt beyond his chairmanship.

Today’s decision by the Federal Reserve to reduce the pace of asset purchases by $10 billion, to $75 billion in January was a modest surprise but not a shock and has been absorbed well by the markets.

The minutes from the last FOMC meeting had already hinted that this was a committee looking for an excuse to begin winding down open-ended QE. To that end, the fact that the economic and labour market data have consistently surprised to the upside in recent months, despite the government shutdown and the uncertainty generated by the debt ceiling standoff, will have reinforced the FOMC’s expectations that growth is set to accelerate in 2014 and that the economy can cope with less monetary accommodation.

In addition, market expectations for the first increase in the federal funds rate remaining consistent with the Committee’s forward guidance in recent months despite tapering becoming increasingly priced into asset prices will have  eased concerns that market participants were not appropriately distinguishing between the two policies.

There may also have been a desire to start heading for the exit under Bernanke’s stewardship, given that he was the programme’s architect, rather than leaving the hard work to his successor. The only dissenter on the Committee was well known dove, Boston Fed President Eric Rosengren, showing how far the policy wheel has turned.

Although there was a solid case for tapering in December, it does not come without risks.

While the recent improvement in economic indicators has been welcome, this is not the first time that the data have strengthened towards the end of the year only for momentum to eventually fade. Moreover, while real economic variables are trending up, inflation is not.

Indeed, the FOMC downgraded its forecasts for underlying inflation further this meeting and now expects core Personal Consumption Expenditure (PCE) inflation, the Fed’s preferred measure of prices, to still be running below its 2% target at the end of 2016. Committee members know this of course but they are now less concerned about downside economic and financial risks, believe forward guidance can be relied upon to do the heavy policy lifting and still think that some of the recent weakness in underlying inflation is temporary.

If Chairman Bernanke’s press conference was anything to go by, there also appears to be an air of resignation in the Committee that there is only so much monetary policy can do to raise inflation in the current environment.

Whether or not they are right in this assessment is the biggest policy question for 2014. After scratching around for a way to reinforce the credibility of the forward guidance, the FOMC ultimately decided against changing the unemployment and inflation thresholds or lowering the overnight interest rate on excess reserves, in large part because they could not build a consensus around any of these options. Instead, the Committee decided to add further qualitative conditions to the forward guidance by indicating that measures of labour market slack beyond the unemployment rate will be taken into account before adjusting policy and effectively stated that rates will not be raised until well after the unemployment rate falls below 6.5%, particularly if inflation remains below 2%.

While de-emphasising the current threshold was necessary given that the unemployment rate is already 7% and will probably fall below 6.5% before the end of 2014, the cost is that the forward guidance policy is much more vague.

The unemployment threshold is now more or less redundant and we do not have clear signposts about what combination of economic, labour market and inflation indicators will trigger the first rate increase. This will place a heavy communication burden on the Yellen-led Fed, particularly if the economy continues to strengthen in 2014 as we expect.

A key risk is that stronger data will be greeted by higher long-term interest rates and, potentially more concerning, expectations of an earlier rate hike, as has occurred in the UK. Taken far enough, this could slow the recovery. On the flip side, any further deterioration in inflation would put the Fed in a very difficult position and probably force them into yet another policy rethink.

Jeremy Lawson, Chief Economist, Standard Life Investments

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