The newly appointed Fed governor Yellen has started her campaign with pushing the, unavoidable, tapering of bond buying further out. Although her statement before the Senate included the following, "I would agree that this program cannot continue forever," most of her testimony focused on the validity of the extraordinary policy that was commenced by her predecessor. That made the markets believe that scaling back these extraordinary measures, especially the bond buying program, could be further away than previously accounted for.
Tapering back on the table
The last few days, however, after strong economic data and the somewhat surprising announcement that U.S. budget negotiators have reached a provisional two-year deal to avert another government shutdown, tapering is back on the table. And, by now, it is probably fair to say that the US economy looks ready for a gradual scaling back of extraordinary measures.
But, the interesting thing is not so much the exact timing of tapering, but the fact that interest rate expectations have remained so benign. Unlike after the first hints Bernanke gave on reducing the amount of bond buying, short-term interest rate expectations have hardly moved at all. This can be seen in the graph below. The graph shows the implied probabilities of different Fed target rate levels for the FOMC meeting held in December of next year. The probabilities can be derived using Fed futures data. I have chosen this particular FOMC meeting as it has functioned as a pivot point concerning the interest rate policy by the Fed.
The graph shows an interesting development of the implied probabilities. Back in August, when Bernanke looked pretty convinced that tapering was near, the probability of higher Fed target rates increased significantly. This happened despite the explicit remarks made by the Fed that a reduction in QE should not be tied to the general interest rate policy. On August 22, the day after the FOMC minutes were released, the cumulative implied probability of a Fed target rate of 50 basis points or more totaled 54%. Thus, the perceived chance of at least one rate hike was bigger than the chance of no hike at all.
QE and rate policy untied
However, the implied probability of a rate hike diminished fast when the Fed refrained from tapering, which was generally unexpected. By October 25 the cumulative probability of a Fed rate of 50 basis points or more was reduced to 23%. But, more importantly, although tapering is now again around the corner, interest rate hike expectations have come down even further. As of December 12 the Fed futures imply there is a probability of less than 10% that the Fed will move before the end of next year.
Hence, the development in Fed target rate expectations indicates that Bernanke and Yellen have finally succeeded in untying the reduction of extraordinary measures like bond buying and the general interest rate policy. This could have a positive influence on investors' willingness to take risk as it takes away some of the uncertainty concerning the regular interest rate policy of the Fed.