Fed Ends QE, Waits on “Forward Guidance”

Going into this week’s Fed Open Market Committee policy meeting, there were really only two questions on the table. This was the Committee meeting when a vote to halt “quantitative easing” purchases of Treasury bonds and mortgage-backed securities was expected. Since QE began in late 2008, the Fed has purchased an unprecedented $4.5 trillion of these securities.

Fed Chair Janet Yellen has made it clear since last spring that the Fed would end its unprecedented bond buying spree by the end of this month. Such purchases hit a high of $85 billion per month late last year, but have since been wound-down to only $15 billion a month. So it was really no surprise that the FOMC voted yesterday to end the QE program.

The other question was whether or not the Fed would change its so-called “forward guidance” as to when it might implement the first interest rate hike. In previous policy statements, the Committee has pledged to keep its benchmark Fed Funds rate near zero for a “considerable time” after QE comes to an end.

One camp of Fed officials wants to drop the “considerable time” phrase. Some don’t like it because they think it overstates how long they are likely to wait before raising rates. Others want it dropped because the timing of the first interest rate hike will depend on the health of the economy, not some pre-set period of time.

ft131217-fig2The other camp of Fed officials wants to leave the considerable time language in the statement this week to avoid rattling the markets, which have been volatile lately because of slowing global growth. These officials wouldn’t want to drop the phrase now and possibly prompt investors to think wrongly that the Fed is likely to raise interest rates sooner than expected.

They would rather wait to adjust the language at the December FOMC meeting, which is followed by a press conference at which Fed Chair Janet Yellen can fully explain any change. And that’s exactly what the FOMC did yesterday:

“The Committee anticipates, based on its current assessment, that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program this month, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal…”

Many investors expect the Fed to start raising its benchmark short-term rate in the second half of next year, a view some Fed policy makers have encouraged.

While most FOMC members remain confident that US economic growth will hit a 3% annual rate in coming months, they don’t want to trigger a repeat of the so-called “taper tantrum” that occurred in the spring and summer of 2013.

At the time, then-Fed Chairman Ben Bernanke’s suggestion that the central bank might begin pulling back on the asset purchases sent bond yields sharply higher in a short time frame and stocks tanked. Ahead of this week’s policy meeting, Eric Rosengren, president of the Boston Fed put it this way:

“Some things in the [policy] statement are going to have to change if we do end the [bond] purchase program. We’ll have to think about exactly what’s the appropriate wording and certainly the financial context that we’re in given the volatility we’ve seen in markets. We’re going to have to weigh how best to avoid further unsettling markets that seem to have unsettled themselves pretty well on their own.”

For all of these reasons, the Committee voted to leave the “considerable time” forward guidance in place at least until the next meeting on December 16-17.

Among the financial developments the Fed is monitoring is the recent surge in the value of the dollar, which could hurt US exports and put downward pressure on inflation, which has been running below the Fed’s 2% target for more than two years. But there’s not much the Fed can do about that.

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This morning, we got our first look at 3Q Gross Domestic Product. The Commerce Department reported that 3Q GDP grew by 3.5% (annual rate), following 4.6% in the 2Q. Today’s number was better than the pre-report consensus of 3.0%. The increase was due primarily to stronger consumer spending and exports.

For the first nine months of this year, the economy has grown by 2.0%.

I may have some additional analysis in next week’s E-Letter.

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