Fed Notes – “Taper Caper” – September 18, 2013


Written by: Jon McGraw

There hasn’t been this much excitement over a Federal Reserve meeting in quite some time.  The FOMC concluded their September event today and all eyes were on the finale of the ‘taper caper’ (yes, we made that up – and of course it’s not fair to pull Carson into the mix but… http://youtu.be/cjquGpmgwOo)

Surprise!  Despite what many economists largely expected, the Fed decided not to pull back on their quantitative easing program of ongoing Treasury purchases of $45 bil./month and mortgage-backed security buys of $40 bil./mo. (some thought the Treasury buys at least, or both, would have been reduced by $10-15/bil. or so per month).  Other comments in the official statement continue to allude to economic expansion at a ‘moderate’ pace and that consumer/business spending has advanced.  However, at the same time, they acknowledged the challenge of elevated unemployment levels and higher mortgage rates (which of course, ironically, were influenced by the earlier ‘taper talk’).

Good decision or not (stock markets love it so far, as do bond markets for that matter), this raises the possibility of tapering to start in October or December.  Why did they hold off?  Perhaps the mortgage decision at least was made based on the rationale that keeping stimulus targeted on housing arguably has a direct and important consumer impact.  The Fed is obviously concerned about mortgage rates in particular rising too far and too fast, potentially destabilizing the housing recovery that’s hit a few speed bumps already recently.

The Fed also released updated economic projections for the next few years—which included 2016 for the first time—and lowered their forecasts for 2013 (from 2.3-2.6% down to 2.0-2.3%) and for the next several years, down to a general range of 2.5-3.5% per year (a wide range as it is).  The Fed’s unemployment and inflation estimates didn’t change much from June, however.  The mixed message puts the Fed in somewhat of a box is that long-term economic growth is expected to be a bit slower than originally anticipated, yet pressure to reduce stimulus is gaining steam.  It obviously can’t go on forever, and that’s likely the realization, but it’s also perhaps a nod to the fact that stimulus by itself can’t prop up growth—and outweigh other factors, such as demographics and longer-cycle factors currently at play (is Japan listening?).

So, what is the Fed looking at exactly in making these decisions?  In keeping with their dual mandate:  (1) inflation, which has been below their 2.0-2.5% target over the past year—they actually want to see this higher; (2) credit/interest rates, which have tightened since the last meeting due to the taper fears discussed ad nauseum—they want credit to remain as ‘easy’ as possible while growth is as low as it is; (3) unemployment, while better than the 8.1% last year at this time, stands at 7.3% today, which exceeds the Fed’s 6.5% initial goal and remains weaker than it could be perhaps due to the sheer severity of the financial crisis and fundamental labor pool issues (lower participation through an aging workforce, mismatch of jobs/available skills, etc.)—they want this to move lower in both structural and cyclical terms.

As a side note, markets definitely appreciated the withdrawal from consideration of Larry Summers as the next Fed chair—to the extent of a 1% pop on Monday.  While arguably more of a politically polarizing choice, he had also shown skepticism as to the effectiveness of continued QE.  The new front-runner, current Vice Chair Janet Yellen, appears much more apt to continue with current Fed thinking.

But don’t expect a radical change in bond prices, all else equal—the taper rumor a few months ago already put that expectation into markets.  However, over the long-term, the removal of QE may be the first in a series of cyclical events that pushes interest rates increasingly upward in keeping with progress in the business cycle.  For other asset classes, continued economic growth and recovery is generally a positive for risk assets like equities, real estate and commodities.