Dialing Down

The financial markets have gyrated in recent weeks on fears that Federal Reserve policymakers will taper the rate of asset purchases. The rise in long-term interest rates and increased market volatility are hard to justify based on the discussion of possible changes in the Fed asset purchase program alone. No change in monetary policy is expected at this week’s Federal Open Market Committee meeting. However, in his post-meeting press briefing, Fed Chairman Bernanke will have to provide a concise and clear explanation of what will drive the decision to eventually dial down the rate of asset purchases.

First, let’s review. On January 15, 2012, the FOMC adopted two long-term policy goals: an inflation rate of 2% (as measured by the annual change in the price index for personal consumption expenditures) and a maximum level of employment. The unemployment rate that is thought to be equivalent to “maximum employment” ought to vary over time and Fed officials will have different opinions on what level that may be. Currently, Fed officials see that unemployment rate goal at 5.2% to 6.0%. The PCE Price Index rose 0.7% over the 12 months ending in April (+1.1% ex-food & energy). The unemployment rate edged up to 7.6% in May. Moreover, that rate understates the level of weakness in the labor market, as many individuals will drop out of the labor force if they cannot find work. Long-term unemployment remains a serious problem and youthful unemployment rates are unacceptably high. The Fed is clearly failing on both of its long-term goals.

Normally, the Fed lowers short-term interest rates to boost economic growth. However, the Fed reached the limit back in December 2008, dropping the federal funds target rate (the overnight lending rate) to a range of 0% to 0.25%. Unable to lower rates further, the Fed has since adopted two extraordinary measures: forward guidance on the overnight lending rate and large-scale asset purchase programs.

In the forward guidance, the Fed makes a conditional commitment to keep the overnight lending rate “exceptionally low” for a certain period. Long-term interest rates are a series of short-term interest rates. Hence, the commitment to keep short-term rates low puts downward pressure on long-term interest rates. In December, the Fed jettisoned the time directive in favor of one based on economic thresholds. Short-term rates will remain low at least as long as the unemployment rate remains above 6.5% and the outlook for inflation one to two years out remains below 2.5% (in addition, inflation expectations have to remain well-anchored). This change did not alter the outlook for short-term interest rates. Note Fed Chairman Bernanke has indicated that short-term rates will remain low even as the economic recovery picks up steam.

The Fed’s Large-Scale Asset Purchase program is now in its third round, commonly called “QE3” (while referred to as “quantitative easing,” it’s really not, but the Fed lost that battle a long time ago). The Fed is currently buying $85 billion in long-term securities per month ($45 billion in long-term Treasuries and $40 billion in agency mortgage-backed securities). The goal of these asset purchases is to lower long-term interest rates, which should help boost economic activity.

The asset purchase program has a qualitative threshold: asset purchases will continue until there is “substantial improvement” in labor market conditions. This phrase means different things to different Fed officials. However, most FOMC members believe that we’re still a long way from that.

Over the years, the Fed has become increasingly open in its communications with the public. Prior to 1994, the Fed didn’t even announce changes to the federal funds target rate. Ironically, that openness is now generating confusion for the financial markets. Many see the Fed as “confused” about what to do. That’s not the case. Rather, there is a range of views at the Fed. Some officials have indicated that they would like to see an early end to the asset purchase program, but that’s far from a majority opinion. The range of views means that it is perfectly appropriate to discuss whether to reduce the rate of asset purchases. That doesn’t mean it will happen anytime soon.

“Tapering” is not the best word, given what the Fed wants to accomplish. It implies a gradual reduction in the rate of asset purchases over time. Instead, the Fed will “dial down” to a slower pace if it believes such a change is warranted. Note that, all else equal, a faster-than-expected reduction in Treasury borrowing (as the budget deficit falls) implies the possibility of a technical adjustment in the rate of Treasury purchases (some reduction in the budget deficit was anticipated).

Recall that it is the total amount of asset purchases that matters, not the monthly pace. There was no appreciable increase in long-term interest rates at the end of QE1 and QE2. QE3 differs in that it is open-ended. We don’t know the total amount of securities that will be purchased. A change in total asset purchases of $500 billion would be equivalent to about a 20-basis-point change in the 10-year Treasury yield. Hence, the decision to reduce the pace of purchases now or somewhat later shouldn’t have a major impact on yields. Of course, investors may worry more broadly about the end of the Fed’s exceptional accommodation, but that is unlikely to happen soon. A full stop in the Fed’s asset purchase program would not be a tightening of monetary policy. That will come when the Fed begins to reduce the size of its balance sheet. The challenge for Bernanke on Wednesday afternoon will be to clearly explain all this. Market fears of Fed tightening should be soothed.

© Raymond James


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