With the continued government shutdown, impending debt ceiling breach and nomination of Janet Yellen to be the next Fed Chair (an event I will fully assess in another post), it was easy to miss the release of the September FOMC minutes. So, here is what you need to know:
- The economy is expanding, but not as fast as they had previously projected: "…meeting participants regarded the information received during the intermeeting period as indicating that economic activity had continued to expand at a moderate pace, albeit somewhat more slowly than earlier anticipated…"
- Fiscal policy uncertainty is a drag on the economy: "Participants discussed the extent to which the ongoing tightening in fiscal policy was likely to further restrain economic activity in the second half of this year… (pointing to) heightened uncertainty about the course of federal fiscal policy over coming months, including the potential for a government shutdown or strains related to the debt ceiling debate, which posed downside risks to the economic outlook."
- The June FOMC statements led to tighter financial conditions that impacted their decision to postpone a reduction in asset purchases. This caused a discussion about future forward guidance and managing market expectations to avoid "undesirable tightening of financial conditions."
- Communication matters and some participants wanted to cut QE just to send a signal that Fed communication is credible. "With the markets apparently viewing a cut in purchases as the most likely outcome, it was noted that the postponement of such an announcement to later in the year or beyond could have significant implications for the effectiveness of Committee communications. In particular, concerns were expressed that a delay could potentially undermine the credibility or predictability of monetary policy by, for example, increasing uncertainty about the Committee's reaction function and about its commitment to the forward guidance for the federal funds rate, with the result of an increase in volatility in financial markets."
- The committee favored cutting Treasury purchases over MBS so as to avoid halting the housing recovery in the near future.
Despite the complexity and importance of each of these points, like a dog with a bone, the news media jumped at the chance to focus on an aspect of the government shutdown and highlight point number 2. For example, Bloomberg news quoted Atlanta Fed President Dennis Lockhart saying "we avoided a potentially very awkward situation of reducing stimulus just on the eve of what now has developed." While this is a fair point and I think it weighed heavily on the Fed's decision to delay tapering, it is inaccurate to attribute the delay solely to fiscal gridlock and ineptitude.
Without a doubt, the FOMC also considered the risk of deflation pointed out by Justin Wolfers, and the possible stimulative multiplier effects of surprising the market by delaying any reduction of asset purchases, as pointed out by Felix Salmon. This is not to say that these influences, even when coupled with fiscal uncertainty, justify the confusion the Fed has caused over their own communications, but the bottom line remains that policy has not really changed. The Fed will taper QE either later this year or early 2014, and the projected timeline for possible increases in interest rates remains roughly the same.
At this point, the bigger question is about how the Fed's surprise "no taper" will impact the credibility of Fed communications (see points 3 and 4) as we move out of the Bernanke era and into the Yellen era. Investors should key on Fed communications more closely than ever during this transition as I expect Dr. Yellen to manage communications more carefully than Chairman Bernanke has. The result will be a tighter Fed message designed to manage market expectations about the pace of stimulus reductions. With careful interpretation, these messages may even identify the pace of reductions (see point 5) and potentially point to how the Fed anticipates the market will react.