Despite recent improvement in the job market, the Fed has still little appetite for a slowing of the central bank’s bond purchases. Nevertheless, we still believe tapering could start by the September FOMC meeting.
While acknowledging the risks of the Fed’s ultra-easy policy stance, Bernanke said today in his prepared testimony to the Joint Economic Committee of Congress that “a premature tightening of monetary policy could lead interest rates to rise temporarily but also would carry a substantial risk of slowing or ending the economic recovery.”
While a scaling down of the Fed’s purchases is not perceived by the central bank as policy tightening we see this statement as clearly dovish. Once again Bernanke expressed concern about the substantial fiscal drag on the economy this year.
As expected, Bernanke’s testimony contained no new information on the key question, namely the timing of any tapering moves. The FOMC minutes released later today might offer more detail of the Fed’s plans.
While increasing QE is possible in theory, we believe the Fed’s next move will be to cut its purchases.
Thus we still expect the Fed to continue its bond purchases at a USD 85bn-per-month pace the next few months, followed by a gradual tapering process toward zero that starts in Q3 2013. The first reduction in the pace of QE is expected at the 17-18 FOMC meeting, which is followed by a Bernanke press conference. This would be in line with the suggestions made by NY Fed President Dudley earlier today, when he said that the Fed could potentially start tapering in “3 or 4 months” but for now there is too much uncertainty about the health of the economy.
Currently we see the risks around this baseline forecast at being skewed towards a later move, with the December 2013 and the March 2014 FOMC meeting as the two most likely alternatives (assuming that any tapering of bond purchases will be announced at a FOMC meeting followed by a press conference). Especially job market data and inflation data will be crucial for any changes to the Fed’s bond purchases.
In an effort to minimise the risk of market disruptions a potential Fed tapering strategy would be to cut purchases by USD 10-15bn per month, leading to a complete halt to QE3 in Q1 2014.
Quantitative easing will only become quantitative tightening once the Fed starts to sell the assets it has bought (or cease reinvesting payments from maturing or prepaid securities on its balance sheet), or drain the additional liquidity in other ways (through reverse repos or term deposits).
Nevertheless, we believe it will be rather difficult for the Fed to convince investors that a halt to QE3 is not a prelude to the exit from easy money. Hence, the most likely outcome is higher interest rates when QE3 eventually is terminated in the context of an improving economy.
Nordea