The Fed statement noted that the downside risks have diminished since the Fall when it more than doubled the size of the its asset purchases. This was coupled with Bernanke's comment that tapering is possible later this year with QE ending purchases around the middle of next year.
These two components outweighed the downgrade in this year's growth and inflation forecast, the first dovish dissent in several years (Bullard wanting to the Fed to be more adamant about defending its inflation objectives in light of the recent low readings.) Although the dollar has been trending lower against the major currencies since late May as the talk of tapering heated up, helped by comments by Bernanke himself, it rallied strongly against the major currencies in the aftermath of the Fed's statement and extended those gains in response to Bernanke's press conference.
Emerging market currencies, which have generally been under pressure, extended their losses. U.S. interest rates rose sharply in response to the Fed and Bernanke. The benchmark 10-year yield rose to new highs. This is likely to trigger a sharp rise in European yields on Thursday and given the linkages with the banks, may weigh disproportionately on financial shares in Europe. The periphery in Europe, which is just seeing preliminary signs of a cyclical recovery is particularly vulnerable.
The U.S. equity market fell sharply and although this would usually pose a challenge for Japanese shares, the weakness of the yen may actually help support the Nikkei (and Topix).
The Fed's statement itself was largely the same as last time, except for the acknowledgment that the downside risks had diminished and that owing partly to transitory factors, inflation was below the committee's long-run objective. Longer-term inflation expectations remained anchored, in the Fed's opinion, though we wonder how much of those expectations are a function of the Fed's QE.
Barring a new deterioration in labor market conditions, we suspect that the inflation story may become more salient in the coming months and Bernanke seemed to confirm this in his remarks.
Contrary to what some critics have argued, the statement and forecasts suggest that the FOMC sees QE3 as being successful in supporting the economy. The Fed's 2103 GDP forecast with a midpoint of 2.5% is still about half a percentage point above the market consensus. This warns that unless there is a substantial change in the pace of growth in Q3, the Fed may revise down its GDP forecast again in September.
The inflation forecast was also lowered to 1.2-1.3% (core PCE) from 1.5-1.6%. Given base effect considerations, this too may be lowered in September's update. So, while those who came into today's meeting expecting the Fed would taper in the September/October period have no reason to change their views, anticipating the next changes in the Fed's forecasts suggests to us that it is far from a done deal.
Bernanke made several points in the press conference that are worth noting, though not unexpected. First tapering is not tightening. Even if the Fed were to reduce the amount of assets it is buying every month, it will be continuing to purchase assets. Second, the thresholds of unemployment and inflation are not triggers of policy. The Fed is not going on automatic pilot and will continue to review the overall economy and set policy accordingly.
Third, the Fed may lower its unemployment threshold from 6.5%, indicating that the goal, which is likely to be what the Fed considers the non-inflationary level of unemployment, is 5-6%. Fourth, there is a consensus at the Fed not to sell the MBS securities it has accumulated. There did not seem to be a reference to its Treasury holdings. Fifth, Bernanke stressed the upcoming data is key. This is not new, but worth emphasizing.
We have anticipated the tapering for late this year, but recognize the risks that this may be pushed into next year. We are concerned like Bullard about the low inflation. We also recognize that the pace of job growth has slowed in the past three months. We also see the advantages of allowing the next Federal Reserve chairperson to taper and in so doing, bolster its anti-inflation credentials.
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