Although summer ended without its usual Jackson Hole punctuation and all political eyes have been fixed on Syria, movement has continued on the monetary policy front. In particular, there has been development on the lingering monetary policy question of when will the Fed begin to taper QE and how rapidly will that taper will occur.
One camp of doves within the Fed has been claiming that as the recovery decelerates, the Fed ought not to be discussing tapering, but ought to be discussing increased stimulus. It is without a doubt that this group of regional Fed Presidents has an economic point. If the justification for QE was to support economic growth, and with the current level of QE growth has decelerated from "moderate" to "modest," then perhaps increased QE is necessary. At the very least, maintaining the current pace of asset purchases is justified. Unfortunately, the reasoning used by this camp of doves appears to be outdated.
The new reasoning at the Fed, and several other central banks around the world, seems to be that QE has limitations and the downside risks of distorting bond markets coupled with limited continuing efficacy suggest that forward guidance is a safer and more effective policy tool. As Matthew Klein at Bloomberg News pointed out, these ideas are largely taken from Columbia University economics professor Michael Woodford. Not surprisingly, Woodford has come out in support of tapering.
While I am normally a big advocate of vote counting on the FOMC based on hawks, doves and everyone in between as a mechanism to determine how the discussion is likely to unfold at the September 17-18 meeting, it has become increasingly clear that the Chairman and Vice Chairwoman are both advocates of greater utilization of forward guidance. In fact, Janet Yellen even gave a speech in April proudly stating:
The Committee was using communication--mere words--as its primary monetary policy tool.
Moreover, this communication strategy has already permeated central banks around the world from the Bank of Japan to the Bank of England.
Given that monetary policy seems to be moving away from QE and toward increased use of forward guidance, it is worth asking a couple of questions:
- How will this strategy impact the pace of tapering?
- How are bond markets likely to respond to increased use of forward guidance?
While the shift in strategy is likely to prompt the Fed to begin tapering asset purchases despite "modest" economic growth, I suspect that the doves will still influence the committee enough to keep the pace of tapering rather slow. So, I maintain that the pace will look much like the one I laid out at the end of August:
This likely means they will pursue a policy of continued asset purchases at a pace of roughly $75 billion per month through October, November and December. Should the economy continue to "modestly" improve, I expect that the December policy meeting will result in a vote to taper down to $60 billion in asset purchases per month beginning in January. Assuming we enjoy the same annual cycle of strong late-winter/early-spring economic growth we have seen in recent years, I expect the voting members of the 2014 FOMC (who are notably more hawkish than the voting members of the 2013 FOMC) to vote for further tapering to $30 billion per month when they meet in March. This would allow the Fed to conclude all asset purchases by the end of June 2014…
The bigger question for investors is how the bond market will respond to tapering and increased use of forward guidance as the primary means of monetary "stimulus." Thus far research from the New York Fed suggests that even when forecasters don't expect a change in the Fed Funds Rate, bond rates rise due to a term premium. Essentially, this means that investors are saying they believe the Fed about forward guidance and acting as though they don't believe the Fed. This issue of credibility is something Fed personnel (especially the next Fed Chair) must address if they intend to use forward guidance as one of the primary levers of Fed policy.
Finally, it is worth noting that tapering asset purchases is likely to have an effect not only on the U.S. economy, but globally. Some research indicates that as much as half of the Fed's QE funds flow offshore, thereby bolstering the economies of U.S. trade partners and developing nations. The loss of these funds could marginally slow global economic growth, but when compounded with the continued conflict in Syria and the impending debt ceiling debate in the U.S., we could be looking at slow global growth for several months and an even greater focus on central bank communication. Investors should closely watch as Fed tapering effects multiple economies and if the Fed and other central banks cannot make their communications more credible to bond markets investors, rates will rise precipitously, regardless of forecaster expectations about the Fed Funds Rate.