“This is the way the world ends
Not with a bang but a whimper.”
– T.S. Eliot
Well, Ben Bernanke wasn’t whimpering yesterday, but the beginning of the end of the Fed’s bond-purchasing stimulus plan wasn’t particularly dramatic. The Federal Open Market Committee decided to “modestly reduce the pace of its asset purchases” by knocking off $5 billion each of Treasury bonds and mortgage bonds, for a total drop of $10 billion per month, while still committing to purchase an additional $75 billion in bonds each month into the indefinite future.
The press release, and the Chairman’s comments, were more positive on the real economy than they have been for some time. “Economic activity is expanding at a moderate pace,” “labor market conditions have shown further improvement,” and “household spending and business fixed investment advanced” covered most of the major drivers of the economy—and all are good. Even government got a reasonably good word, from an economic perspective. Although the usual caveats were included, notably on housing, this is probably as good an economic take as we were going to see from the Fed. The final conclusion that “economic growth will pick up from its recent pace and the unemployment rate will gradually decline” is pretty much what we all want to see going forward.
Interestingly, as positive (in Fed terms) as the statement is, the actual cut was small, and the Fed went out of its way to underline that policy support would continue indefinitely, with any further tapering depending on continued economic improvement, and low rates expected to continue until well past the time the unemployment rate drops past 6.5 percent, which is not expected until 2015 or later.
The positive tone, then, concealed a great deal of uncertainty about the endurance of the recovery. There are a couple of reasons for this. First, the last thing the Fed wants is a general conviction that everything is really all right, as that would drive interest rates up past its ability to manage them and potentially derail the current positive trends. Second, the next last thing the Fed wants is for equity markets to react to those rising interest rates by dropping. By trying to thread the needle, by emphasizing that the economic recovery is well under way—but not so strong that stimulus and low rates will be cut any time soon—the Fed is hoping to start the taper that the real economy is ready for without spooking the financial markets.
At least as far as yesterday goes, it succeeded in a big way. Markets popped, clearly considering the taper a good sign, and reversing a recent downswing. Interest rates did increase slightly, but not in a scary way. Today’s numbers are a bit more mixed, but, overall, markets remain ahead of where they were before the announcement.
On balance, I do think the taper is a good thing. I agree with the Fed’s take on the recovery, insofar as I think that additional stimulus is, at a minimum, becoming much less necessary. I expect the taper to continue, probably ending by the end of 2014. Interest rates should climb during the year as the taper completes.
I am not sure I agree with the market’s reaction yesterday. Other things being equal, higher rates imply lower values for stocks, and the start of the taper means higher rates are on their way. Insofar as the market is pricing in both economic growth and continued support, I suspect the Fed may be willing—assuming growth continues—to pull back a bit faster than expected. The first step is the hardest, and now that we’ve crossed that hurdle, further reductions will be easier.
One of the reasons I think this is that the Fed is still buying a heck of a lot of bonds. Even with the “modest reduction,” the Fed will still buy almost a trillion dollars’ worth of bonds in the next 12 months. There have been signs the Fed is getting nervous about the costs of the program, and those costs will continue to rise. If economic growth continues, the cost-to-benefit equation will change for the worse very quickly.
Markets today seem somewhat less cheerful, suggesting yesterday wasn’t necessarily a change in trend back to positive. Now, with the Fed having started the taper, and with the government actually close to finalizing a budget agreement, there can’t be too many more positive surprises lurking out there that could juice the market. The next month or two should therefore give us a good idea of what’s coming next.