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Wednesday, October 30, 2013

Fed Comment

(NOTE: Feedburner did not e-mail out yesterday's post, as far as I can tell.  Here is the link to the article, for those of you who follow by email. I hope the problem is fixed; otherwise I will have to track down what's happening tomorrow.)

The lack of movement by the Fed today was not a big surprise. Since there was no press conference, they would have caused total chaos if they did something. The consensus is moving towards March 2014 as being the start of the "taper".  However, there remains a small possibility that they could do a small cutback in purchases in December. If they wait too long, they will lose their policy flexibility.

If the Fed starts reducing the pace of bond buying by $10-$15 billion a month per meeting starting in March 2014,  the Fed will only exit Quantitative Easing (QE) in early 2015. This is fairly close to the consensus date for the start of rate hikes, based on the last published forecasts of Fed policy committee members (although those forecasts were made before the government shutdown).

Without a lengthy pause after the period of QE and before the expected first rate hike, markets will probably conclude that "tapering" is tightly linked to the timing of the first rate hike. They will ignore chatter from policymakers arguing that there is no linkage between the two events. The yield curve will back up to price in rate hikes that are starting relatively soon.  As such, yields would be higher than the peak we saw this year. Policymakers will have to sure that the economy is ready to stand such an interest rate shock as soon as they first announce the taper.

Since the economy is not going to improve that much before March 2014, policymakers may be unwilling to risk tapering purchases. The end result is that they may have trapped themselves; they will only be able to exit QE at almost the same time that they are ready to hike rates. The only way to regain flexibility is to create a credible belief that there will be a pause between the end of QE, and so they would have to start winding it down well before the rate hikes are expected to start.

(c) Brian Romanchuk 2013

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