Yesterday, the FOMC decided to reduce the pace of its large scale asset purchase program from $85 billion per month to $75 billion per month. The Fed has long wanted to taper its LSAP program and move to forward guidance to normalize policy but the data weren’t strong enough. Ben Bernanke pulled off this transition in masterful fashion, setting the stage for more market upside. Headwinds are building though. Building inventories, earnings disappointments and a lack of wage growth are my principal concerns.
The Taper Details
As I wrote in yesterday’s commentary, I had expected a December taper but my doubts on December tapering grew because hawks seemed to suggest tapering was wrong. Instead, the hawks believed the Fed should end QE aggressively or in one fell swoop. But as it stands, the Fed is set to end the QE program late into 2014 by pulling back the LSAP program in tiny steps. Here’s how the Fed addressed the issue in its statement yesterday. I have pulled out only the most salient points.
Information received since the Federal Open Market Committee met in October indicates that economic activity is expanding at a moderate pace…
…The Committee expects that, with appropriate policy accommodation, economic growth will pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate… The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.
…in light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to modestly reduce the pace of its asset purchases. Beginning in January, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $35 billion per month rather than $40 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $40 billion per month rather than $45 billion per month…
…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…
…Voting against the action was Eric S. Rosengren, who believes that, with the unemployment rate still elevated and the inflation rate well below the target, changes in the purchase program are premature until incoming data more clearly indicate that economic growth is likely to be sustained above its potential rate.
So what led us here? First, the Fed has long recognized that asset market froth is an outgrowth of accommodative monetary policy. Janet Yellen spoke to this regarding QE back in 2010. In fact, this is an instance in which the Fedwanted asset markets to rise, particularly housing as rising house prices would end household deleveraging as a threat to sustained recovery. QE2, operation twist, the Fed’s third round of easing focused on permanent zero, and QE3 were all undertaken because the economy fell out of bed and the Fed was concerned that deleveraging would tip the US back into recession.
We have to remember that fiscal policy has been unusually tight. Ambrose Evans-Pritchard called it “the most drastic austerity cuts since demobilisation at the end of the Korean War in the 1950s.” In the Fed’s post-tapering presser yesterday, Bernanke also remarked that fiscal policy had been a headwind, noting that the US has had “unusually tight fiscal policy for a recovery period.”
And so the Fed believes that the fact that the US has had a recovery at all owes to monetary policy. He made this very clear during the presser, echoing remarks that he has made consistently over the past few weeks – I believe in part in order to cement his legacy as Fed Chairman. Ambrose agrees:
The diverging fortunes of the QE bloc and the EMU bloc prove beyond doubt that monetary stimulus packs a powerful punch. Without becoming entangled in the vendetta between Friedmanites and Keynesians – I value the insights both in the post-bubble phase, as well as “Austrian” insights before the bubble builds – the central bank experiment of 2008-2013 shows that blasts of money can greatly offset the pain of budget cuts, even when interest rates are zero.
And I agree with Ambrose and Bernanke as well. The question is not whether one gets a recovery though. The question is the quality of that recovery and the secular durability of its roots. Unlike Ambrose, I do often quibble on this point, because fiscal policy is still neutered and QE-style monetary policy is emblematic of the trickle-down, asset-based economic model.
Putting this aside, the Fed became uncomfortable with QE as a policy too early in the year. Jeremy Stein led the way. But even Bernanke was uncomfortable with the market’s reaching for yield. So QE was killed. The question about the death of QE has never been an ‘if’ question; it has been a ‘when and how’ question. The Fed wanted to move to taper as quickly as possible but the backup in yields after even the mention of tapering was so devastating that tapering was delayed again and again. We’ve finally got it now though.
Why taper? What was so bad about QE from the Fed’s perspective? Bernanke told us frankly at the presser what the problem was in retrospect: the term premium.
Basically, the Fed was always concerned that QE had an immensely positive effect on risk-seeking behavior and in retrospect it seems like this ‘reaching for yield’ has been more than the Fed was comfortable with. Jeremy Stein told us in October that he doesn’t think that central banks should lean against asset bubbles. And Bernanke echoed this sentiment at the presser. Instead, Fed officials seem to believe that keeping asset prices in mind, monitoring them, and considering them as central banks make policy is a more appropriate response.
Moving from QE to forward guidance as the focal point of policy, while still remaining accommodative, accomplishes this. If you recall, the original response to tapering in May was violent. The Fed had already seen the reaching for yield, the currency war effect as hot money moved into emerging markets. But after tapering, we had this massive uptick in US yields that risked cratering the housing recovery and was also crushing EM as hot money fled. The Fed legitimately feared another recession and perhaps even a crisis. This after merely suggesting QE was going to be reduced, not ended.
It was interesting to hear Bernanke discuss this yesterday. The May incident taught the Fed that it was making the right choice. QE was combustible stuff for the markets and Bernanke yesterday pointed at the term premium for why. He basically said that QE monkeyed with the term premium instead of with forward rate expectations, and thus had a disproportionately large impact on risk-seeking behavior. Bernanke was saying that the Fed was more comfortable altering forward rate expectations than the term premium because doing so created a more balanced trade-off between positive effects of monetary policy on the broader economy and the negative effects of reaching for yield and risk.