Thursday, December 19, 2013

Taper time

The Federal Open Market Committee decided today to get on with the job of reducing the pace of their asset purchase program.  The Committee decided to reduce the program by $10 billion per month to $75 billion per month, cutting both Treasury and MBS purchases by $5 billion each.  Markets have responded well, bolstered by changes to the language around their forward guidance which reinforces that interest rates will remain low for a long time.

The Committee noted recent data which “indicates that economic activity is expending at a moderate pace”.  Indeed our read of the data has been that the labour market data has become more consistently solid and that is showing through in real economic activity such as household spending.  If the Committee hadn’t announced a tapering decision today, they would have at least had to acknowledge they were very close to doing so.

Market reaction has reflected that while the Committee announced a reduction in their asset purchase program, the overall tone of the statement was on the “dovish” side.  Firstly, the Committee said that the future path of tapering was not on a pre-determined path and would remain data dependant. So long as the labour market continues to improve and inflation moves back towards its long run objective “the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings”.

Secondly, forward guidance was strengthened, but through their use of language rather than the expected change to the level of the unemployment rate at which they would consider interest rate increases.  The Committee states that “it likely will be appropriate to maintain the current target range for the Fed funds rate well past the time that the unemployment rate declines below 6.5%, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.”   Previously the Committee had signalled to maintain the current target range for the Fed funds rate at least as long as the unemployment rate remains above 6.5%.

Importantly, the decision to start tapering has removed a major distraction for markets.  The key risk around tapering risk was always the initial announcement.  But today demonstrates the Committee continues to manage its communications exceptionally well.  Furthermore, since the decision in September not to taper, markets have become increasingly comfortable with the idea.  That has of course been helped by the recent strength in the data.

The overriding message today is that while the US economy still requires the ongoing support of low interest rates for some time to come, there has been sufficient improvement in the fundamentals to justify the winding back of asset purchases and that given the outlook, particularly for inflation, it will be a long time before interest rates need to rise.  That’s all good news.