The Fed’s September 18 decision on whether to begin reducing the pace of asset purchases will depend on the economic data (the job market figures, in particular), but there’s a growing consensus that we’re likely to see a modest initial step, as a compromise between Fed officials who want to end the program sooner and those that want to see it continued. There are other things for policymakers to consider. One is the possibility of an adverse reaction in the financial markets. Another concern is the low underlying trend in inflation.
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Ex- food and energy, the PCE Price Index rose 1.2% over the 12 months ending in June, well below the Fed’s official target of 2.0%. In its July 31 policy statement, the FOMC noted concerns that “inflation persistently below the 2% objective could pose risks to economic performance.” However, the committee added that it “anticipates that inflation will move back toward its objective over the medium term.” This is a contrast to a decade ago, when Ben Bernanke, then a new Fed governor, led the charge against the possibility of deflation (a general decline in the overall price level). Bernanke said deflation should be “strongly resisted” by the central bank and listed tools that could be used even if the federal funds rate hit its zero bound. He noted that the possibility of outright deflation was remote at the time, “due in large part to the determination of the Federal Reserve to act preemptively against deflationary pressures.”
In contrast, Bernanke has appeared more complacent about the possibility of deflation in recent months. Part of that is due to the expectation that the recovery will continue to gather steam in the months ahead. Factors restraining growth (tighter fiscal policy, in particular) should fade. St. Louis Fed President Bullard formally dissented in the June 19 policy statement, citing concerns about low inflation. Evidently, he wasn’t the only one with such concerns at the July 30-31 FOMC meeting.
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The reaction to the tapering talk of the last few months has been surprising. No one should have expected the asset purchase program to last forever and the consensus opinion at the start of 2013 was that Fed asset purchases would likely stop by the end of the year. Tapering is not tightening. The Fed will be adding policy accommodation even as it slows the rate of asset purchases and will continue to provide significant support to the economy through its forward guidance on the overnight lending rate. In fact, the Fed views forward guidance as being much more effective in keeping long-term interest rates low, a sentiment being adopted by other central banks.
There may be some concern that higher long-term interest rates will dampen the pace of the recovery. There’s limited evidence of that so far, home and auto sales, two interest rate-sensitive sectors, appear to have held up well. However, other economic data reports have been mixed, consistent with a lackluster-to-moderate pace of growth overall. If we do see signs that long-term interest rates are dampening growth, that slower growth should likely lead long-term interest rates back down. Fed asset purchases are not the sole determinant of long-term interest rates.
The Fed will be watching for an adverse reaction in the financial markets. Recall that there was no significant impact on long-term interest rates following QE1 and QE2. However, QE3 differs in that it is open-ended. The stock market did react poorly after the two earlier stages of asset purchases ended. An increase in asset prices was part of the goal of QE3. However, the Fed does not base monetary policy on the level of the stock market, nor is it about to start.
Prior to FOMC meeting, the Fed surveys the primary dealers and others regarding expectations of what it will do. Those expectations have begun to gel recently, but the economic data will be the key factor as we head toward mid-September.
© Raymond James
