The Fed's Tapering Catch-22

by: Jeffrey Rosenberg

So much for tapering talk. The Fed surprised the markets by continuing its program of $85 billion per month of purchases of US Treasuries and mortgage-backed securities (and clarified in the Q&A it didn’t mind doing so). But the lack of tapering represents a missed opportunity to begin what will eventually be required. Tightening financial market conditions - the rise in interest rates following the Fed’s May-June comments on tapering - appear to be the reason for today’s surprising decision to defer the moderation of purchases.

Clearly the Fed signaled the concerns it has with higher mortgage and interest rates - parts of the tightening in financial market conditions. The Fed understands that the economic recovery is relying on interest rate-sensitive segments of the economy and is being held back by the narrowness of job and income growth. Financial market conditions - rising housing and stock markets - provide the main source of support for the recovery in the form of supporting a wealth-induced incentive for spending. That spending comes about as consumers are saving less - not through rising incomes. And that leaves the economy too vulnerable to financial market conditions, a point central to our year end rate expectations (updated here) and underscored by the Fed’s actions.

The problem now is how does the Fed communicate its intent to taper the next time without causing rates to rise once again? It’s a Catch-22. Creating tighter financial market conditions - higher mortgage and interest rates and lower stock markets - are the very things that the Fed cited for the decision to not taper. And the Fed may have backed itself into a corner.

In addition, we received more forward guidance from the Federal Open Market Committee participants regarding their expectations for growth, employment and inflation, and the forward path of Fed policy rate. These forecasts indicate "full employment" by 2016, yet the consensus expectation for the Fed Funds rate at that time falls around 2% - well below the “long run” estimates for a 4% rate? The conclusion has to be the Fed doesn’t believe those forecasts indicate a “normal” recovery in employment. The decline in market interest rates today reflects the slower path of Fed policy rates indicated in these forecasts.

So how can the Fed taper without tightening financial market conditions? The answer will be to strengthen forward guidance and emphasize that this guidance is a more important tool for monetary policy than QE. The Fed set the stage for those future changes and likely will do that at its next attempt at exiting QE. When that will happen will be subject to the incoming economic data. For now however the prior guidance of 7% unemployment rate and expectations of the end of the quantitative easing bond buying program by mid-2014 are off the table.

What should investors expect? Now that the Fed has pushed expectations for low rates out yet again, the performance of risky assets should do well in such an environment, but their long-run results will be challenged - much as they were in May and June - if and when the Fed decides it is time to try another go at exiting its program.