A Glide Path for the Fed: Earlier, But More Predictable and Flexible Tapering

  • The Fed began the process of ending QE and thereby kicked off the end of a 30-year long cycle of progressively easier monetary conditions.
  • In starting the tapering process earlier than expected, the Fed has traded off incremental adjustments in the pace of its asset purchases against greater predictability and flexibility in its policy.
  • While beginning the “Long March Back” from experimental policy, the Fed provided detailed and explicit Forward Guidance, enhancing its conventional interest rate toolkit.
  • Successfully convincing markets of a self-sustaining recovery while maintaining a supportive monetary stance could create a “sweetspot” for risk-based assets and EM in 2014.

The Fed has finally done it. After much prevarication and false alarms, it has sounded the bell for an end to the 30-year period of declining interest rates. The move had come at the early end of expectations, with markets split three ways between December, January and March. To be sure, policy rates will stay on hold for a considerable period, but – assuming that there won’t be a need for QE4…QEn – US monetary policy has now shifted gear and is no longer poised for greater easing. That being said, this is an extremely gradual process: not only will monetary policy remain extremely accommodative, but it will become more so throughout 2014 – only at a reduced pace.

In short, the Fed announced the following:

  • A reduction in the pace of its monthly asset purchases by $10 bn from its current $85 bn, beginning in January 2014 (allowing markets to end 2013 without further disruptions). That is, it will add $35 bn MBS and $40 bn of USTs to its balance sheet per month.
  • Envisaging “measured reductions at each meeting”, with “similar moderate steps going forward throughout most of 2014”
  • Indicating that interest rates would not rise until unemployment rate was “well past 6.5%”.
  • Lowering the median interest rate forecast for end-2015 from 1.0% to 0.75% and for end-2016 from 2.0% to 1.75%.

What does this mean for markets?

1. It matters

Some have dismissed the move as marginal and as a non-event. We beg to differ. First, whether $10 bn is a large or a small number relative to the Fed’s $4 trn balance sheet is not the right question to ask. A broader issue is at play here. This is the vexed and much-debated question whether it is the size or the flow of the Fed’s balance sheet that matters. If it is the former (the stock), then the reduction in the flow is indeed de minimus. The reason for believing in this approach is that the expanded monetary base will remain in the economy and the end of QE will only halt a further increase. All else equal, the Fed’s balance sheet will deflate only very slowly as the securities it holds come to maturity (unlike the ECB, which lent money for a maximum of 3yrs and witnessed both scheduled and early repayments in 2013, prompting a 20% balance sheet contraction from peak). The flow approach instead relies on the portfolio balance effect, namely the shift in portfolio allocation towards riskier, higher yielding assets triggered by artificially depressed yields on government securities. The economy benefits from this effect only in a roundabout way through a collateral increase in investment, lending and, ultimately, consumption.

Given this context, it is immediately clear that both flows and stocks matter. The size (stock) of the Fed’s balance sheet has the most direct impact on the economy, whereas the flow works itself through financial markets first and the economy subsequently. It is thus no surprise that market participants are so sensitive to the QE/tapering discussion, even if only comparatively small amounts are involved.

2. It’s more predictable

The move also matters in that it establishes a predictable path for the extrication from the Fed’s (open-ended) QE program. Predictability is what was amiss during 2013 and led to wild gyrations in asset prices as prospects for tapering waxed and waned. The Fed’s announcement establishes a “glide path” that will see it end its asset purchases not before September 2014.

3. It’s more flexible

Naturally, the Fed will not tie down future policy unconditionally, much to the market’s chagrin. Chairman Bernanke reiterated his previous statements that the Fed would not hike interest rates until unemployment was well past the 6.5% unemployment threshold. Markets had previously ignored this point as it was couched in “Fed-speak”. But as always, the Fed allowed for caveats here too: in this case, it will remain in accommodative mode only as long as the inflation objective remains unthreatened. Similarly, Bernanke indicated that the Fed “could skip a meeting or two” or that it “could go a bit faster” if economic conditions warranted it.

All told, the immediate market reaction was fairly favorable in DM-space, with a drop in the VIX, a bounce in the S&P, the USD firmer, the Nikkei jumping and gold off. The picture is more mixed in EM-space with the MSCI down on the whole but Latin America up. The EM FX reaction was more uniformly negative but in equity space it was China, India and Turkey which stood out as the clearest casualties.

Yet, EM and risk-based assets in general could find themselves in a sweetspot against this backdrop of clearer Fed policy. Compared to 2013, the global policy context for 2014 represents a sea-change and should sharply reduce market volatility: predictable continued easing, albeit at a diminished pace, is about as good a flight path as markets could wish for.

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