FOMC Statement: 2nd Reaction

by: Tim Duy

We now have Federal Reserve Chairman Ben Bernanke's press conference behind us, and we will be pulling it apart for nuances and insights for days. What I expected going into this presser was this:

Bernanke will attempt to detail how exactly the data flow is supportive of scaling back asset purchases in the next few months (I believe the Fed prefers September) while at the same time disassociating asset purchases from interest rate policy.

Of course, Bernanke did not say September. But I think he made clear that assuming the Fed's forecasts hold, it sees that asset purchases will be gradually reduced beginning later this year with the expectation that the Fed will draw QE to a close by the middle of next year. He confirmed my suspicion that although the Fed sees the fiscal sector as a drag on overall growth, it does not believe it has harmed the underlying momentum of the economy. I would even say that he sounded relatively optimistic. Thus, downside risks have diminished and it is appropriate to begin reducing accommodation.

Interestingly, he seemed to set a trigger, not a threshold, for ending QE -- the program should be concluded when unemployment hits 7%. I am surprised that he set a number, although it is consistent with the idea that the Fed wants to end QE well ahead of the 6.5% threshold for unemployment. Watching the unemployment rate just became even more important, as a faster-than-expected move to 7% will be associated with a faster end to QE.

Bernanke took pains to separate the winding down of asset purchases, which the Fed believes is a reduction of accommodation, and the decision to tighten by raising interest rates. He made clear that 6.5% was not a trigger for higher rates, and implied that rates would stay near zero well past the 6.5% threshold -- especially if inflation remains low. I believe he was trying to anchor rates in the face of the announced (yes, data-dependent) timeline for ending QE. If he was, it didn't work -- 10-year yields rose sharply today.

Bernanke continued to deflect attention from the low inflation numbers, describing them as largely transitory and identifying the impact of the sequester on medical payments as a factor. Here is what I think is going on: Overall, the Fed has basically a Phillips Curve view of inflation. Low inflation now is attributable to high unemployment. Given that unemployment is forecast to fall, and the forecasts are improving such that it is falling faster than anticipated, it anticipates that disinflation will soon be halted. In other words, right now policy is being driven by the unemployment rate. The more quickly unemployment moves toward the Fed's long run target, the more it will reduce accommodation despite low inflation. At least, that is what it appears to be.

Bottom Line: Yes, as always, everything is data-dependent. But the Fed believes the current path of data is sufficient to justify scaling back and ending the asset purchases program. Tightening policy via rate hikes, however, is still far in the future.