The Federal Reserve Tapers: In Search of Calmer Waters

Yesterday’s decision by the Federal Reserve’s policy committee to modestly reduce (“taper”) its purchases of U.S. Treasury and mortgage-backed securities was a turning point in a number of respects.  After a long period of public debate that roiled markets, the Federal Reserve has at last begun what is likely to be a gradual and well-telegraphed exit from its period of extraordinary stimulus.  Together, last week’s fiscal deal and the Federal Reserve’s taper decision appears to have marked the start of a period of relative calm where U.S. macro policy uncertainty will be far less of a driver of markets. That’s good news for the global economy.

A few observations on the decision.

1. The decision yesterday to cut purchases by $10 billion to $75 billion represents a very small reduction in stimulus–worth just a few basis points on the long-term interest rate—and was easily offset by a more dovish statement and forecast for the future path of policy (“forward guidance”).  Equity markets rose on the announcement and Treasuries held their ground.  The Volatility Index (VIX), a measure of market uncertainty, fell 15 percent on the news. The Federal Reserve may see the response as reflective of its credibility; maybe, but it also reflects that the decision was significantly priced into markets and underscores the value to markets to resolving uncertainty.
2. The path outlined by the Federal Reserve yesterday, a steady and gradual reduction in purchases (likely ending sometime in mid-to-late 2014) followed by a “liftoff” in rates sometime in 2015-16, means that policy remains highly accommodating and will only incrementally tighten. Even after purchases end, the Federal Reserve’s large balance sheet means that policy remains easier than if they had simply stopped when interest rates hit zero.  Policy remains data dependent, but one month or two of good data will not change this bottom line.
3. Global inflation pressures remain muted and, given the amount of slack globally, is likely to not be a problem for policymakers in the near term.   The Bank of Japan will likely have to do more next year to meet their 2 percent inflation target.  The Federal Reserve’s move turns up the heat on the ECB—I expect we will see quantitative easing (QE) in Europe next year.  While Bernanke rightly highlighted that there were transitory factors helping to constrain inflation that could be reversed, the more likely scenario is that central banks will continue to worry more about deflation.  That too will introduce “stickiness” to policy.
4. Looking ahead, forward guidance will be a relatively more important tool of policy, and QE less important.  This parallels a shift among economists—inside and outside the Fed—in thinking about what is most effective at influencing financial conditions.  Simply put, successive rounds of QE were less effective, relative to the potential benefits to credibly committing to maintain low rates for a long period. Forward guidance will be data dependent and markets will continue to price in changing expectations about the future.  But the payoff to clear commitments will tend to make policy changes more cautious and, hopefully, well telegraphed and therefore less noisy for markets.
5. The Federal Reserve yesterday needed to address its former guidance that an unemployment rate of 6.5 percent was a threshold for considering a rate hike, something it may regret having said as the unemployment rate has fallen faster than expected. Some expected a lowering of the threshold to 6 percent, but the Federal Reserve instead shifted to a qualitative commitment:  “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 was a clever way to get the message out while softening the focus on the unemployment rate going forward.
6. As we know from its minutes and speeches, the Federal Reserve Board has been sharply divided on the question of tapering.  It should come together now.  Certainly there will be disagreements over how much to taper at any individual meeting and how to communicate, but these differences seem small compared to the debate that has played out over the past year.  It often has felt that Federal Reserve communication reflected as much a negotiation in public among Fed members as it was forward guidance to the public.  If so, this decision will make Janet Yellen’s communication task easier, and would be another reason why the taper decision was well timed.

Over the past few years, both monetary and fiscal policy has been an extraordinary source of uncertainty.  Last week’s fiscal package took one set of risks off the table, and while the debt limit extension could be noisy (an increase is expected to be needed in March but could be stretched till May/June) the incentives for another crisis seem low for both parties. Now we have a monetary policy framework that markets seem to understand and welcome.  Together, the reduction in uncertainty could be quite constructive for investment and growth.