News in Charts: Markets Shrug Off ‘Taper-lite’

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The Fed reserves its right to surprise – much like it did back in September. This time it was by taking action rather than refraining from it, although it is fair to say that the prospect of a policy change after this FOMC meeting had attracted a flurry of late bets in recent days.

The tapering process was always going to be gradual. Nevertheless, this week’s announcement was as close as the Fed could get to doing nothing without actually doing nothing – a ‘taper-lite’ if you will. Chairman Bernanke announced an initial reduction of $10 billion split evenly between Treasuries and MBS. At the post-meeting conference it was acknowledged that reductions of a similar size were envisaged going forward. And of course it is hard to avoid the conclusion that reductions of this magnitude at each of next year’s eight FOMC meetings would pretty much get you to zero purchases by December 2014. Crucially, we were told that the decision had Ms Yellen’s full support. It would have been presentationally difficult, if not impossible for the Committee to vote for a policy that did not have the support of its future Chair. And that may account for the extremely doveish nature of the FOMC statement, with the Fed enhancing its forward guidance by stating that the policy rate will be kept near zero ‘well past’ the time when unemployment reaches the 6.5% threshold.

The statement contained two important changes of emphasis. First, the Committee felt that risks to the economic outlook, previously described as ‘tilted to the downside’, had become ‘more nearly balanced’. Second, and taking into account the substantial fiscal retrenchment that had taken place since the launch of the current asset purchase programme, the Committee saw the improvement in economic activity and labour market conditions as ‘consistent with growing underlying strength in the broader economy’.

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We share the Fed’s evolving optimism. We were confident that this year’s fiscal tightening, which viewed through the lens of the cyclically-adjusted primary balance was equivalent to more than two percentage points of GDP, and represented the most aggressive tightening since at least the late 1980s, would not derail the recovery. Moreover, we felt strongly that the US was ready for tapering even back in September. In that respect it is striking that the Committee’s latest projections for the US economy, published alongside yesterday’s policy statement, have barely budged over the past three months. It is probable that concerns about spillovers from the political in-fighting in Washington, together with alarm at the rapid increase in long-term borrowing costs that took place through the summer, are what caused the Committee to pull up short back in September. But now things have changed. The risk of another government shutdown in 2014 should be taken off the table once the ‘Bipartisan Budget Act of 2013’ is ratified by the upper Chamber of Congress. Just as important, perhaps, is that the market appears to have come to terms with the Fed’s message, pushed hard over the past three months, that ‘tapering is not tightening’ – for example the 30-year mortgage spread is now at far lower levels than it was during the summer.

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Inflation remains low and falling, justifying a cautious approach. And although the Committee did not go so far as to introduce an explicit inflation floor, it did instead make a strong commitment to a highly accommodative bias, ‘especially if projected inflation continues to run below the Committee’s 2% longer-run goal’.

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Collectively, FOMC participants forecast that the 6.5% unemployment threshold will be hit sometime in late 2014 – our own judgment is that, if the monthly change in non-farm payrolls stays close to 200k, and if the recent downward trend in participation continues, then it will happen a little sooner than that. Nevertheless, most FOMC participants do not expect to see an increase in the Federal Funds rate until late 2015.

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Markets have taken ‘taper-lite’ in their stride. Equities have advanced, the dollar has risen a little and Treasury yields have barely moved – in short markets are discounting a milder, longer taper. It remains to be seen whether the positive momentum in risky assets will be sustained. It is possible that we will see some loss of momentum in equity markets as the Fed continues to reduce, albeit very gradually, the pace of asset purchases. Nevertheless, our central expectation is that the US will continue to outperform other developed economies. If the US was ready for tapering back in September, it certainly ought to be well placed to accept ‘taper-lite’ now.

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