The FOMC has decided to continue asset purchases at their current pace: $40 billion/month of MBS and $45 billion/month of Treasuries. In earlier posts I indicated that the odds of tapering beginning in September were better than 50/50 with the remaining odds indicating tapering will begin in either October or December. I also acknowledged that economic conditions did not warrant tapering asset purchases, but a shift in focus to forward guidance as the primary Fed policymaking tool increased the likelihood of the committee voting in favor of tapering. While I believe that this shift in policy focus away from asset purchases (and the downside risks associated with them distorting markets) and forward guidance is still afoot, economic conditions are weaker than anticipated and the impending debt ceiling debate (again) coupled with possible further cuts to fiscal expenditure deeply concerned members of the FOMC.
While many analysts are likely to focus on nuanced chances in the press release (such as dubbing economic growth as "moderate" as opposed to "modest"), I prefer to queue on the Chairman's words in the press conference. During the course of an hour-long statement and Q+A session Bernanke made a few things very clear:
- Unemployment/underemployment is still too high and inflation is "persistently low."
- Fiscal policy and the uncertainty surrounding it are limiting economic growth.
- The Fed Funds Rate will not rise for over a year, probably more like two.
As per usual, the Fed Chairman began his statement with a direct reference to the dual mandate by explaining that any reduction in asset purchases is not yet warranted because unemployment/underemployment are still too high and inflation remains "persistently low." These conditions were also true at the FOMC's last meeting, but they still hinted at tapering asset purchases. So, the question is whether the doves on the committee convinced everyone (including the Chairman) that the economy was not strong enough to justify tapering, or if something else prompted this apparent reversal.
While I believe the doves have had some impact on the Committee's thinking, the bigger trigger here was clearly fiscal policy uncertainty. Chairman Bernanke could not quite hide his annoyance at Congress as his tone of voice became uncharacteristically gruff with every mention of fiscal policy. In particular, Bernanke stated that "federal fiscal policy continues to be a restraint on growth." He went on to say that "substantial fiscal headwinds" are hampering growth by "a percentage point or more." In direct response to a question, the Chairman clearly stated that "upcoming fiscal debates pose significant risk to the economy" and implied that he is more concerned about the international and credit implications of another debt ceiling debate than any uncertainty about a government shutdown.
In discussing the Committee's economic projections Bernanke pointed out that the FOMC expects the unemployment rate to be between 6.4% and 6.8% in the 4th quarter of 2014. With 6.5% unemployment remaining a threshold for the Fed to raise interest rates. This means that the earliest we can anticipate a hike in the Fed Funds Rate is the end of 2014 (assuming inflation remains low and stable). However, Bernanke was quick to point out that 6.5% unemployment is a threshold, not a trigger. So, the first rate hike may not occur until unemployment is "significantly below" target, depending on labor market conditions, particularly participation. This explains why 12 of the 17 members expect rates won't rise until some point in 2015 and two expect them not to rise until 2016. Perhaps more important for investors, homeowners and anyone seeking credit, the median projected Fed Funds Rate for the end of 2016 is only 2%.
While many will view the lack of tapering as positive economic news, it is actually a signal of how fragile the Fed perceives the economic recovery to be. Their concern about fiscal policy uncertainty only highlights that they do not see the economy as strong enough to weather another storm. That said, it is obvious that Fed personnel are keenly aware of the downside risks of continued asset purchases and their distortion of markets, so they are still likely to taper asset purchases beginning later this year. While Bernanke tried to claim that he could hold a special press conference or phone call to explain tapering if done in October, given the fiscal policy time frame, it is much more likely that the Fed won't announce tapering of asset purchases until December. Initiating tapering in December would still give the Fed the opportunity to conclude purchases by the end of summer 2014 without shocking markets. This would also allow the Fed to transition to a forward guidance oriented approach roughly a year before rates are likely to rise.
Essentially, this means that the whole timeline for Fed stimulative action has been pushed back 3 months as a result of fiscal policy uncertainty. So, investors should enjoy low rates while they last, but keep in mind they are around to buoy the economy from irresponsible government action and weak recovery in the labor market. It is also worth noting that the Chairman did respond directly to a question about the spillover effects of U.S. monetary policy on emerging markets. His response was essentially that our policy will impact them and it may not be good for most markets, but on balance it is good for the global economy so stimulus will continue. Keep that in mind as you weigh your investment options in emerging versus developed markets.