So much for tapering talk. The Fed
surprised the markets
by continuing its program of $85 billion per month of purchases
of US Treasuries and mortgage-backed securities (and clarified in
it didn't mind doing so). But the lack of tapering represents a
missed opportunity to begin what will eventually be required.
Tightening financial market conditions -the rise in interest
rates following the Fed's May-June comments on tapering -appear
to be the reason for today's surprising decision to defer the
moderation of purchases.
Clearly the Fed signaled the concerns it has with higher
mortgage and interest rates - parts of the tightening in
financial market conditions. The Fed understands that the
economic recovery is relying on interest rate-sensitive segments
of the economy and is being held back by the narrowness of job
and income growth. Financial market conditions - rising housing
and stock markets - provide the main source of support for the
recovery in the form of supporting a wealth-induced incentive for
spending. That spending comes about as consumers are saving less
- not through rising incomes. And that leaves the economy too
vulnerable to financial market conditions a point central to our
year end rate expectations (updated
) and underscored by the Fed's actions today.
The problem now is how does the Fed communicate its intent to
the next time
without causing rates to rise once again? It's a Catch-22.
Creating tighter financial market conditions - higher mortgage
and interest rates and lower stock markets - are the very things
that the Fed cited for today's decision to not taper. And the Fed
may have backed itself into a corner.
In addition, we received more forward guidance from the
Federal Open Market Committee participants regarding their
expectations for growth, employment and inflation, and the
forward path of Fed policy rate. These forecasts highlight a key
question: how is it that the average of these forecasts indicates
full employment by 2016, yet the average of Fed policy rate
expectations falls around 2% - well below the long run estimates
for Fed policy rates of 4%? The conclusion has to be the Fed
doesn't believe those forecasts indicate a "normal" recovery in
employment. The decline in market interest rates today reflect
the slower path of Fed policy rates indicated in these
So how can the Fed taper without tightening financial market
conditions? The answer will be to strengthen forward guidance and
emphasize that this guidance is a more important tool for
monetary policy than QE. The Fed set the stage for those future
changes and likely will do that at its next attempt at exiting
QE. When that will happen will be subject to the incoming
economic data. For now however the prior guidance of 7%
unemployment rate and expectations of the end of the quantitative
easing bond buying program by mid-2014 are off the table.
What should investors expect? Now that the Fed has pushed
expectations for low rates out yet again, the performance of
risky assets should do well in such an environment, but their
long-run results will be challenged - much as they were in May
and June - if and when the Fed decides it is time to try another
go at exiting its program.