(Fed) Talk is cheap. So don’t listen

  • Recent market perceptions notwithstanding, the Fed is unlikely to end its accommodative stance (incl. QE) anytime soon. However, this does not mean that asset markets will continue to derive undiminished support from such actions forever.

Markets have recently taken fright following the Fed’s seemingly more hawkish stance in its latest Minutes, which are being interpreted as pointing to an earlier-than-expected end to its QE3 program. The operational statement in the latest FOMC minutes was that it would “vary the pace of asset purchases” in light of the perceived costs and benefits of the operation and that it may “taper or end its purchases before… a substantial improvement in the outlook for the labor market”.

However, in reality, this is unlikely to herald a change in the Fed’s current, accommodative stance: indeed, the Fed “varied” the pace of purchases before, twice ending it prematurely before resuming it aggressively. What is more, the current state of the economy does little to suggest that QE should be ended soon: true, unemployment has fallen from a peak of 10.0% in October 2009 to 7.9% in January of this year, but it remains elevated and part of the decline owes to disproportionately slow growth in the labor force. Meanwhile, GDP inches along at an anaemic 1.5% yoy clip and CPI remains significantly below the Fed’s 2% long-term objective (1.6% yoy in January 2013) . The fiscal drag from the imminent sequestration of government spending beginning on March 1 is likely to add additional headwinds to growth.

The brunt of the argument which could lead to an earlier termination of asset purchases (USTs or MBS) lies in the trade-off between the costs and the benefits of these actions. The framework for this had been laid out during Ben Bernanke’s Jackson Hole speech in August 2012 and the debate has received renewed impetus in a recent speech by Governor Jeremy Stein on the risk of the formation of a credit bubble. Bernanke had delineated four types of risks related to the Fed’s asset purchases: 1) an impairment of the functioning of credit markets, 2) a reduction in the public’s confidence in the Fed’s ability to achieve a smooth exit from its accommodative policies (thereby unmooring inflation expectations), 3) risks to financial stability and 4) the possibility of financial losses to the Fed should interest rates rise to an unexpected extent. Bernanke judged at the time that none of these risks presented an imminent danger. His judgment and that of the majority of FOMC members continues to prevail. Indeed the committee “remains concerned that, without sufficient policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions”. Furthermore, as in previous instances, it “expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens”.

Markets should parse the signal from the noise. An academic debate – all the more so conducted among the “participants”, not the “members” of the meeting – does not represent policy guidance. The Fed now operates under quantitative objectives. And as long as the inflation rate does not rise above 2.5% and unemployment remains above 7% (likely throughout 2013), it is unlikely to budge from its previous commitments. This being said, even if those commitments are upheld, it is true that the benefits of accommodative policies are becoming harder to discern (and the evidence mainly resides in the counter-factual space). As valuations reach/exceed pre-crisis levels, asset markets will thus derive ever-diminishing support from accommodative monetary policies.

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