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Wednesday, December 18, 2013

Taper! Taper! Taper!

Well that was exciting. So far my forecast that this would be viewed as a policy error was wrong, but in my defence, it's too early to say...

The key points to note:

  • Fed monthly purchases drop by $10 billion to $75 billion per month; $5 billion each from Treasury and mortgage paper;
  • ignore that 6.5% unemployment rate triggering rate hikes thing; rates can remain at zero as long as inflation is well behaved.

My reading is that the baseline scenario should be:
  • Purchases reduced by $10 billion at each Fed meeting in 2014. This means that the end of 2014 is the end of QE (there are 8 Fed meetings per year).
  • Fed rate hikes commence shortly thereafter (early 2015). 
This appears slightly more hawkish than what is priced into the forwards, but not by much. However, it seems consistent with the published consensus FOMC forecasts. The Fed wants bond market participants to believe that there will be a lengthy pause in between the end of QE and rate hikes, but we do yet not have enough information to believe them. It appears that risks may be skewed towards the Fed being less hawkish than this baseline, explaining why forward rates are below what the path of Fed funds it implies.

The initial financial market reaction was entertaining. So far, equities are up on the news. There goes the forecasts that "the Fed can never Taper because of stocks". But it may be possible that the initial reaction is an incorrect read on future trends. However, it is nice to see the Fed having the will to act in December, despite the worries about the reaction of illiquid markets. The Fed needs to break its reputation of kowtowing to the needs of the equity markets.

(c) Brian Romanchuk 2013

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