As widely expected, the Fed decided today to trim its monthly bond purchases by USD 10bn to USD 65bn, sticking to the plan outlined by departing Chairman Bernanke in December. The reduction is evenly split, with the Treasury purchases cut by USD 5bn to USD 35bn and the MBS purchases trimmed by USD 5bn to USD 30bn. The decision to tapering was unanimous.
With a slightly more positive tone regarding the assessment of the economy, Fed officials seem to view the surprisingly weak December jobs report and the recent sell-off in equity markets in the context of more positive broader trends. Thus the Fed said that “growth in economic activity picked up in recent quarters.” The central bank also observed that household spending and business fixed investment both “advanced more quickly in recent months.” “Labor market indicators were mixed but on balance showed further improvement. The unemployment rate declined but remains elevated,” the FOMC statement said.
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Going forward, we believe the Yellen-led Fed will stick to the course, bringing an end to QE later this year, probably in October.
The FOMC statement repeated the message that the Fed will likely keep rates unchanged “well past” the unemployment rate reaching 6.5%, “especially if projected inflation continues to run below” the 2% longer-run goal. Thus the threshold still does not matter very much as long as inflation is low.
We still see the first Fed rate hike in early 2015. However, when wage and inflation readings start to pick up later this year, we expect markets to start questioning the Fed’s – “irresponsible” and time inconsistent – commitment to keep the real Fed funds rate negative through 2016. The result will be further increases in bond yields this year as expectations for the fed funds rate in 2015 and 2016 go higher.
Reverse repo facility extended
Today the Fed also extended and increased the size of its overnight fixed-rate reverse repurchase facility. Under the programme, in place since September and otherwise set to end this week, the Fed lends bonds from its large holdings of Treasury securities in exchange for cash from eligible financial firms. The daily allotment for the reverse repurchase agreements was increased to USD 5bn from USD 3bn.
The reverse repo facility will be one of the Fed’s primary policy tools when it eventually decides to start raising interest rates. Thus it will allow the Fed to control short-term interest rates without having to drain the trillions of dollars of excess reserves pumped into the banking system. By changing the interest rate offered on this tool, the Fed will effectively be able to set a floor for short-term interest rates.
However, we see today’s extension of the programme as a technical development allowing the Fed to continue testing the facility, and not as a sign of an imminent rate hike.
Nordea