Fed Burned Once Over Taper Now Twice Shy on QE3
U.S. central bankers have $3 trillion of losses reminding them they had better get their communications right should they decide to taper their bond purchases.
That’s how much global equity markets declined in the five days after Federal Reserve Chairman Ben S. Bernanke’s June 19 remarks that he may reduce his $85 billion in monthly securities buying this year and halt it altogether by mid-2014. His comments pushed the yield on the benchmark 10-year Treasury to a 22-month high.
Since then, he and his colleagues have sought to convince investors that paring stimulus doesn’t signal a tightening of monetary policy. They will need to reinforce that message to prevent another premature interest-rate rise if the Federal Open Market Committee goes ahead with the move, said Ward McCarthy, chief financial economist at Jefferies LLC in New York.
“They want to get back to a neutral balance-sheet policy but that doesn’t mean they want rates to skyrocket here,” said McCarthy, a former Richmond Fed economist. “The market is hypersensitive,” and the taper represents “the beginning of the end” of unprecedented monetary stimulus.
The policy-setting FOMC probably will reduce the pace of its bond buying next month, according to 65 percent of economists surveyed Aug. 9-13 by Bloomberg. Its first step may be small, cutting monthly purchases by $10 billion to a $75 billion pace, according to the median estimate of 48 economists.
The minutes from the Fed’s July 30-31 meeting reveal policy makers’ anxiety. They describe “volatile” financial markets in response to “policy communications” and economic data, and U.S. interest-rate increases that signaled “heightened financial-market uncertainty about the path of monetary policy.”
Fed officials were “broadly comfortable” with Bernanke’s plan to start reducing bond buying later this year if the economy improves yet decided against adding any more information about the outlook for asset purchases in their July policy statement. They “judged that doing so might prompt an unwarranted shift in market expectations,” according to the minutes, which were released Aug. 21.
“I’d be pulling my hair out if I were on the FOMC,” said Jerry Webman, chief economist at OppenheimerFunds Inc. in New York, which manages more than $208 billion. “It’s premature for them to be reducing their stimulus, but to back down from a signal they’ve sent to the market for the last month or so -- I’m concerned about what message that sends.”
Bernanke said in June that the reduction in asset purchases may come this year if economic performance improves as projected. Joblessness has declined to 7.4 percent from 7.8 percent in September, the month the FOMC announced its third round of bond buying. Payroll growth during the past six months has averaged about 200,000 compared with about 141,000 in the six months before September 2012.
Inflation -- at 1.3 percent as measured by the personal-consumption-expenditures price index -- is falling short of the central bank’s 2 percent goal.
Fed officials expect unemployment of 7.2 percent to 7.3 percent this year, according to the central tendency estimates of policy makers’ June forecasts, which exclude the three highest and three lowest. They projected inflation of 0.8 percent to 1.2 percent.
Webman said he expects the Fed will taper by $10 billion because that would avoid sending “a more pessimistic view of the economy” to investors, even though “it’s hard to argue the economy is accelerating.” Barring “fantastic data,” it would be “very risky” to cut purchases by more than that, he said. “The market would be pretty disturbed by the Fed doing more than a token taper in September.”
Yields on the 10-year Treasury note have climbed to a two-year high on speculation the FOMC will slow its purchases next month. Benchmark 10-year yields were little changed yesterday at 2.88 percent after climbing to 2.93 percent, the most since July 2011. That’s up from 1.63 percent on May 2, according to Bloomberg Bond Trader prices.
The Standard & Poor’s 500 Index gained 0.9 percent to 1,656.96 (SPX) yesterday.
“It’s been a bit of a muddled message,” said Bret Barker, a managing director in U.S. fixed income at Los Angeles-based TCW Group Inc., which manages more than $128 billion. “In theory, QE3 was meant to target unemployment and the labor market. I’m not really sure there has been substantial improvement in the labor market, but they seem to want to end the program.”
Barker said he anticipates the Fed will lower the pace of its bond buying by $20 billion, which may create more volatility in the markets since most investors predict the $10 billion change. Barker also said he doubts the Fed will be able to control longer-term interest rates once monetary policy is on hold as traders will be expecting tightening.
“I can somewhat believe they will help anchor front-end rates, but I have a hard time believing the Fed can anchor anything in the long-end spectrum,” Barker said.
Bernanke used remarks in Cambridge, Massachusetts, on July 10 and his July 17 testimony before the House Financial Services Committee to try to divorce a tapering of bond purchases from the Fed’s interest-rate outlook, saying July 17 that “highly accommodative monetary policy will remain appropriate for the foreseeable future.” He also said the central bank’s asset purchases “are by no means on a preset course” and could be reduced more quickly or expanded as economic conditions warrant.
“They’re trying to distinguish between slowing down the easing and actually tightening policy and -- at least initially -- that distinction was lost on the markets,” said Dana Saporta, an economist at Credit Suisse Group AG in New York. “Only time will tell how much success they’ve had.”
Policy makers said they saw the Fed’s communications since June as “having helped clarify the Committee’s policy strategy” that decisions about paring asset purchases are “distinct” from interest-rate increases, according to the minutes from the July meeting.
Saporta predicts the Fed will taper its purchases by $20 billion in September, with cuts split evenly between mortgage-backed securities and Treasuries. The central bank is currently buying $45 billion a month of Treasury debt and $40 billion a month of the housing-related assets.
An uneven distribution between the two would risk “complicating the message,” and “it’s probably best for now to keep the initial taper as simple as possible” given the Fed’s difficulty in communicating over the past few months, Saporta said.
Since the “Fed was surprised by the intensity of the adverse reaction” to Bernanke’s remarks in May and June, policy makers may want to “at least communicate that the tapering process may be a leisurely one,” Saporta said.
The chairman’s comments on May 22 that the Fed could “take a step down in our pace of purchases” in the “next few meetings” sent Treasuries falling and erased gains in the stock market.
U.S. stocks and bonds also fell on Aug. 21 after the July minutes showed officials support the timeline for reducing stimulus.
“Part of the problem in May and June was that it was really hard to decipher what their message was,” McCarthy said. “They will be very careful to try to communicate what they’re doing, when they’re doing it and why they’re doing it.”
To contact the editor responsible for this story: Chris Wellisz at email@example.com