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What worries the Federal Reserve the most currently is whether the economy can cope with a gradual unwinding of monetary easing. The U.S. economy is clearly further along in its recovery than it was over the past couple of years, when quantitative easing was expanded, which makes exit talk much more credible. The problem is that the answer may not be found in economic theory, because the Fed has chosen to manipulate asset prices since the global financial crisis of 2008-09.

Thanks to an accommodative monetary policy around the world, central banks have managed to artificially boost asset prices in recent years. Japan has been the latest case, but the recent sell-off in Japanese equities (JPP) and sovereign bonds has shown central bank actions may be starting to have undesired effects. The Fed is trying to find out what it can expect by allowing the possibility that it will soon start to unwind quantitative easing, usually referred as tapering. This way they are managing expectations so that when they decide to do it, the effects will be smoother because they were largely anticipated.

Given that the economy and financial markets in general have become addicted to this cheap money, if the result of tapering will be increased volatility and declining asset prices, the Fed will certainly become reluctant to unwind its quantitative easing. Effectively, as soon as Ben Bernanke mentioned the possibility of an earlier tapering of bond purchases, the U.S. treasury market sold off. Equity prices (SPY) have also declined recently, but one could argue that is only a minor correction from the gains achieved since the beginning of the year. Nevertheless, it is obvious that without a strong economic backdrop asset prices will be vulnerable to the Fed's policies. Should the economy stagnate over the next months, the Fed will need to step on the monetary gas with even more force than before.

Furthermore, the Fed has placed great importance on a recovery in the U.S. housing market and its latest quantitative easing round directly targeted mortgage rates. Usually central banks use quantitative easing to buy treasury bonds to target long-term interest rates, keeping them low to make credit cheaper for households and businesses. However, the Fed went one step further by buying mortgage backed securities, directly targeting the borrowing costs for U.S. households. Mortgage rates have therefore remained low for the past few years, supporting the housing recovery from its worst crisis in decades. But as I have discussed recently in my previous article Housing: Is this recovery for real?, the housing market recovery has some weak points that seem to question its sustainability. Add to this the recent spike up in mortgage rates and the housing recovery theme may fall apart much more rapidly than the Fed expects.

Conclusion

The U.S. economy has recovered significantly since the global financial crisis of 2008-09, but it still remains fragile and its growth is below average. The Fed is discussing the possibility to withdraw, at least partly, quantitative easing but if the result of this rhetoric is plunging asset prices and eventually a growth slowdown, the Fed may try to delay the moment it begins to move out of quantitative easing. Moreover, the housing market may not be strong enough to accommodate higher mortgage rates, leaving the Fed with no other alternative than to continue to pursue quantitative easing for some more time.

Source: Why The Fed Will Not Taper