Last week Federal Reserve (the Fed) officials surprised investors by choosing not to begin slowing the pace of quantitative easing (QE) despite months of setup in their public comments. Instead, the latest iteration of the Fed’s bond buying strategy will continue at $85 billion per month. At this point our best guess is that the decision was a path of least resistance among a divided committee: there seemed to be a number of officials who were concerned about downside risks to growth from fiscal policy uncertainty and higher interest rates. Although we think this is the most plausible explanation for their decision, we remain surprised by how little data it took to dissuade the committee. Fed officials appear to have little conviction about the economy even after four years of expansion.
We would emphasize three main points from last week’s news:
First, despite the delay, tapering is still coming. The initial moves toward slowing the pace of QE were triggered by an improvement in the economy. Unless economic activity unexpectedly turns down, Fed officials will still need to respond by adjusting policy relatively soon. We now expect the initial tapering announcement to come at the December 17-18 meeting, just before Chairman Bernanke steps down.
Second, Fed communication also changed in subtle but important ways. Most notably, Chairman Bernanke appeared to back away from the unemployment-based guideposts the committee was using for QE and the funds rate. In June he indicated that the FOMC would likely conclude QE when the unemployment rate reached 7%. At last week’s meeting he failed to mention the 7% threshold, and when asked by a reporter he responded that “the unemployment rate is not necessarily a great measure.” He also said in prepared remarks that the funds rate might remain at zero even if the unemployment rate “is considerably below 6.5%”—deemphasizing the other threshold. Lastly, he said that the committee continues to discuss possible innovations to its forward guidance, which might be introduced in coming months. These communication changes should have more lasting effects on interest rates than the temporary delay of QE tapering.
Third, separate from the FOMC meeting, various media outlets indicated that Janet Yellen is now the leading candidate to succeed Ben Bernanke. The Washington Post reported that White House staffers began calling Senate Democrats to gauge support for her candidacy. This should be incrementally positive news for rate markets, given Yellen’s strong support for the Fed’s easy policy stance and the fact that her views are widely known by investors.
Looking ahead, the natural question for fixed income markets will be how long the Fed tailwind lasts. We have not changed our broader interest rate outlook on the news, and continue to expect long-term rates to drift higher as the economy recovers. The Fed’s more cautious stance may encourage a more gradual increase in rates, but as long as growth holds up, it won’t prevent it altogether.
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