In a surprise move, the FOMC this evening refrained from scaling down its asset purchases. The market reaction was significant with the 10-year treasury yield dropping 15bp on the announcement and the 2-year yield 6bp, while equities rallied and the S&P500 rose 1.3%.
The overarching reason that the Fed opted to do nothing at the meeting is the recent tightening in financial conditions and, in particular, the increase in mortgage rates. Bernanke stated that the FOMC wants to be sure that the impact on especially the housing market does not bring economic growth out of sync with the Fed’s projections. Another factor mentioned is fiscal policy and the risks associated with the upcoming debate on both the debt ceiling and the 2015 budget. We have two meetings left this year in October and December. One month more of data is likely not enough to judge whether the tightening in financial conditions is derailing the recovery. It is also uncertain whether the fiscal situation will be much clearer end October. This favours waiting until the December meeting to taper.
Other factors supported the dovish feel. In particular, the new year-end 2016 forecasts showed both unemployment and inflation back close to their longer-term neutral levels, but the median projection of the Fed funds rate at only 2% up from 1% year-end 2015. This is basically in line with the market pricing ahead of the meeting and even slightly below. A neutral Fed funds rate is seen around 4% and the projections suggest that the average FOMC member is in line with vice chairmwoman Yellen’s statement, that the Fed funds rate should be kept much lower than what a Taylor rule would suggest. At the press conference, Bernanke explained that because of continued headwinds (slow housing market, continued fiscal drag, lagged effects from the financial crisis) he expected the Fed funds rate to remain below 4% for two-three years after 2016.
It is also worth noting that the QE plan Bernanke laid forward at the press conference following the June FOMC meeting was not reaffirmed. He did not mention the 7% unemployment rate threshold for ending QE, neither did he talk about mid-2014 as a likely end point. Rather, he used the more vague formulation "first step on tapering is possible later this year".
In sum, the FOMC is considering when to moderate its purchases and the decision remains data dependent - as the statement put it, "there is no preset course for asset purchases". In our view, however, the December FOMC meeting is the most likely candidate for a start to tapering.
The overarching reason that the Fed opted to do nothing at the meeting is the recent tightening in financial conditions and, in particular, the increase in mortgage rates. Bernanke stated that the FOMC wants to be sure that the impact on especially the housing market does not bring economic growth out of sync with the Fed’s projections. Another factor mentioned is fiscal policy and the risks associated with the upcoming debate on both the debt ceiling and the 2015 budget. We have two meetings left this year in October and December. One month more of data is likely not enough to judge whether the tightening in financial conditions is derailing the recovery. It is also uncertain whether the fiscal situation will be much clearer end October. This favours waiting until the December meeting to taper.
Other factors supported the dovish feel. In particular, the new year-end 2016 forecasts showed both unemployment and inflation back close to their longer-term neutral levels, but the median projection of the Fed funds rate at only 2% up from 1% year-end 2015. This is basically in line with the market pricing ahead of the meeting and even slightly below. A neutral Fed funds rate is seen around 4% and the projections suggest that the average FOMC member is in line with vice chairmwoman Yellen’s statement, that the Fed funds rate should be kept much lower than what a Taylor rule would suggest. At the press conference, Bernanke explained that because of continued headwinds (slow housing market, continued fiscal drag, lagged effects from the financial crisis) he expected the Fed funds rate to remain below 4% for two-three years after 2016.
It is also worth noting that the QE plan Bernanke laid forward at the press conference following the June FOMC meeting was not reaffirmed. He did not mention the 7% unemployment rate threshold for ending QE, neither did he talk about mid-2014 as a likely end point. Rather, he used the more vague formulation "first step on tapering is possible later this year".
In sum, the FOMC is considering when to moderate its purchases and the decision remains data dependent - as the statement put it, "there is no preset course for asset purchases". In our view, however, the December FOMC meeting is the most likely candidate for a start to tapering.
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