The Fed surprised investors a second time by deciding to taper its asset purchase program. The consensus among economists and Wall Street analysts was a reduction in either January or March meeting. Nonetheless, the decision should not come as a surprise since the Fed explicitly stated that the tapering of QE is data dependent. Looking at recent data, economic growth has picked up and a reduction in the asset purchase program is warranted given the margin benefit does not exceed the marginal cost.
Key Points in Today's Statement:
The main key point in today's statement is that the Fed finally starts to taper QE but it offsets some of the negative impact by changing its statement regarding its forward guidance. The assessment made in the statement showed that the Fed is more comfortable about the economic outlook after recent fiscal uncertainties abated and the labour market improved.
The Fed decided to taper its $85 billion monthly bond purchases by $10 billion, spread evenly between a $5 billion reduction in treasury purchases and $5 billion reduction in MBS purchases. In the statement, the Fed stated that the economic recovery has strengthen enough to start reducing stimulus:
In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to modestly reduce the pace of its asset purchases. Beginning in January, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $35 billion per month rather than $40 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $40 billion per month rather than $45 billion per month
To reduce investors' anxiety regarding today's tapering decision, the Fed added some new language to remind investors that tapering is not tightening. As the Fed Chairman explained in his June press conference: "Tapering is similar to letting the foot off the gas". The Fed will still grow its balance sheet, albeit at a slower pace.
The Committee's sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery
In addition, Fed officials decided to alter its language on forward guidance to offset potential negative reaction to the tapering decision:
The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal.
Therefore, the Fed decided to ease the 6.5% threshold and remind investors that it has not forgotten about its inflation mandate. Given the core PCE is below 1% (see graph 3 below), the Fed may not hike the fed funds rate until the unemployment rate drop substantially below 6.5%.
Data Pointed to a Dectaper:
In Bernanke's September press conference, the Fed Chairman told reporters that the asset purchase program is not on a preset course and it is data dependent. Looking at the nonfarm payrolls data, job creation has improved substantially since the start of QE3. The 12 month rolling average for nonfarm payrolls was 150K before the program and the current 12 month rolling average is near 200K (See graph 1). The economy created 200K+ jobs for the second month in a row in November, despite the uncertainties created by the government shutdown. Graph 2 shows that the 3 month and 6 month rolling nonfarm payrolls increased near the 200K level. The 200K level is important because many Fed officials stated in their prior speeches that 200K is the minimum acceptable run-rate for the economy. Other data such as the ISM survey (see graph 4) shows a better improvement in the underlying economy.
Graph 1: Monthly Nonfarm Payrolls
Graph 2: Rolling 3-Month and 6-Month Nonfarm Payrolls Averages
Graph 3: Inflation Measures (Core PCE and Core CPI)
Graph 4: ISM and New Orders-Inventory Spread
Outlook for Policy Ahead:
The Fed also released their economic projections from its 19 FOMC members. The projections show that the unemployment rate is expected to drop to 6.3-6.6% by the end of 2014 and 5.8-6.1% by the end of 2015. For core PCE inflation, it is projected to end 2014 at 1.4-1.6% and 1.6-2.0% in 2015. Coupled with its new language on forward guidance, it appears that a first rate hike may not occur until mid or late 2015 when core PCE inflation reaches near the Fed's 2% target and the unemployment rate is near 6.0%. The Fed will continue to reduce the size of QE as long as incoming data does not deteriorate. However, the reduction will be gradual as stated in today's statement. The Fed will taper QE in "measured steps" and will likely end the program by mid or late 2014.
Implication for Investors:
Surprisingly, both equities and bonds rallied. Today's decision to taper shows that the Fed is more confident regarding the economic recovery. The improved outlook for the economy should be positive for risk assets such as equities. Although bonds rallied (yields dropped) today, I expect yields to rise gradually over the medium term as the Fed continues to taper off QE in 2014.