Fed Finds Elixir for Tapering QE as Markets Embrace Rate Outlook
For six months, the Federal Reserve has struggled to engineer a pullback of its bond-buying program without unhinging financial markets. Yesterday, the Fed did it.
After the Fed and Chairman Ben S. Bernanke expressed enough confidence in the jobs outlook to taper the pace of asset buying and extended the timeline for zero interest rates, U.S. stocks surged to record highs and 10-year Treasury yields rose just six basis points. That’s the opposite of Bernanke’s experience in June, when global equity markets lost $3 trillion in the five days after he said he might reduce his $85 billion in monthly bond purchases this year and end it by mid-2014.
Since then, policy makers have tried to convince investors that tapering quantitative easing isn’t tightening policy. They succeeded yesterday by coupling a $10 billion reduction in monthly asset buying with a stronger commitment to keep interest rates at record lows, according to Ward McCarthy, chief financial economist at Jefferies LLC in New York.
“The Fed is trying to get policy back in the direction of normal without causing setbacks in the economy and too much distress in financial markets,” said McCarthy, a former Richmond Fed economist, who predicted the Fed would taper. “Based on the initial reaction, they found a magic elixir.”
The Standard & Poor’s 500 Index rose 1.7 percent yesterday to 1,810.65, its biggest gain in two months. Yields on the benchmark 10-year Treasury note climbed 0.06 percentage point to 2.89 percent, according to Bloomberg Bond Trader prices. That’s below the 2.99 percent reached Sept. 5 on speculation the Fed would taper that month. In September, the Fed refrained from tapering in part because of the rise in borrowing costs.
Bernanke said yesterday his actions were “intended to keep the level of accommodation the same overall and to push the economy forward.”
For the past year, the policy-setting Federal Open Market Committee said that it would probably hold its benchmark rate near zero “at least as long as” unemployment exceeds 6.5 percent, so long as the outlook for inflation is no higher than 2.5 percent.
Yesterday, the Fed reinforced its assurances that interest-rate increases are far off by saying its benchmark rate is likely to stay low “well past the time that the unemployment rate declines below 6.5 percent, especially if projected inflation continues to run below” its 2 percent target.
Inflation measured by the personal consumption expenditures price index rose 0.7 percent for the 12-month period ended in October, and the jobless rate last month was 7 percent.
“It’s an important achievement” that markets are showing confidence in the Fed’s interest-rate outlook, said Columbia University economist Michael Woodford. He urged central banks to adopt “forward guidance” as a form of stimulus at a Kansas City Fed symposium in 2012 before the Fed established the unemployment and inflation thresholds.
“They have been trying for some time to get across the point that expectations about the path of asset purchases and about the path of interest rates should be two separate things, but earlier in the year, there seemed to be some confusion in the markets about that,” Woodford said. Yesterday, the Fed “underlined the difference quite firmly and the market reaction suggests that this is now considered credible.”
Money-market derivative traders pushed back their expectations for the timing of the first increase in the target for the benchmark federal funds rate, which has been between zero and 0.25 percent since December 2008.
Forward markets for overnight index swaps, whose rate shows what traders expect the fed funds effective rate to average over the life of the contract, signal a quarter percentage-point advance in about August 2015, according to data compiled by Bloomberg. That compares with a Dec. 17 projection of a first increase in about July 2015.
Bernanke said yesterday that policy makers had started their third round of asset purchases in September 2012 to provide an “additional boost” and that once “the economy had grown and was moving forward, that at that point we could begin to wind down the secondary tool, the supplementary tool, and achieve essentially the same amount of accommodation using interest rates and forward guidance.”
“And so I do want to reiterate that this is not intended to be a tightening,” Bernanke said in his last scheduled press conference before his term expires Jan. 31. Fed Vice Chairman Janet Yellen’s nomination to succeed him is pending before the Senate.
Fifteen of 17 FOMC participants forecast the first interest-rate increase in 2015 or later, compared with 14 in September.
Bernanke said that the “cost-benefit ratio” of quantitative easing “moves in a way that’s less favorable” as the size of the Fed’s balance sheet grows. The Fed’s assets rose to a record $3.99 trillion as of Dec. 11, up from $2.82 trillion in September 2012.
“The Fed has seemingly convinced the market that the new tool of choice is forward guidance and not asset purchases,” said Bret Barker, a managing director at TCW Group Inc. in Los Angeles, who helps oversee $85 billion in bond investments. “The takeaway seems to be they want out of the program even though they haven’t hit all of their targets.”
Unemployment fell to a five-year low in November as employers added a greater-than-forecast 203,000 workers to payrolls. Joblessness was down from 10 percent in October 2009, during the recession, and up from 4.4 percent in May 2007.
Fed officials raised their assessment of the outlook for the job market, predicting joblessness will fall to as low as 6.3 percent by the end of next year, compared with a September projection of 6.4 percent to 6.8 percent.
Joblessness may be falling faster than U.S. central bankers have expected in part because people are exiting the workforce due to discouragement, retirement, disability, or a decision to stay in school.
The labor force participation rate -- the proportion of the working-age population either holding a job or looking for one - - was 63.6 percent in September 2012 and has fallen to 63 percent. That can drag the unemployment rate lower, because job seekers who stop looking for work are no longer counted as part of the labor force.
“If we’re making progress in terms of inflation and continued job gains, then I imagine we’ll continue to do, probably at each meeting, a measured reduction” in purchases, Bernanke said, calling $10 billion in the “general range” for a “modest” reduction. If the economy slows, the Fed could “skip a meeting or two,” and if the economy accelerates it could taper a “bit faster.”
“They have gotten cold feet about the open-ended nature of what they got into,” said Jonathan Wright, an economics professor at Johns Hopkins University in Baltimore who worked at the Fed’s division of monetary affairs from 2004 until 2008. “They are trying to set this up on a plan, so long as the data come in as expected, that would make an incremental change at each meeting.”
Separating the pace of asset purchases from the outlook for interest-rates is an “important step in the process of normalizing policy,” making “clear” the mix of stimulus tools can be changed without affecting the level of accommodation, said Tim Duy, a professor at the University of Oregon in Eugene and a former U.S. Treasury economist.
“For the longest time, the markets had been confused -- they viewed tapering as tightening,” said Scott Brown, chief economist at Raymond James & Associates Inc. in St. Petersburg, Florida. “They’re finally getting the message.”
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