Fed asset purchase continues apace

Very much as anticipated by the market, yesterday’s statement from the Federal Open Market Committee was very similar to that released after the Committee’s last meeting on September 18. The pace of large-scale asset purchases ($85 billion per month) was unchanged. And there were no adjustments to the economic thresholds for hiking rates (6.5% unemployment, 2.5% inflation, etc.)

To the extent there were language revisions in the statement, they mainly lined up on the hawkish side of the ledger, suggesting that last month’s concerns about higher interest rates and the risks they represent have moderated. Thus the Committee could have re- characterized economic activity as “modest” but stuck with the “moderate pace” language it used last month.  The first paragraph of the statement did note that “the recovery in the housing sector slowed somewhat in recent months.” But all references to elevated mortgage rates were eliminated.  Then in paragraph two, the FOMC removed its September 18 reference to “the tightening of financial conditions observed in recent months” and deleted that section altogether.

Also, the Committee did not assert that it is “prepared to increase or reduce the pace of its purchases” as it had before September. Rather it focused on conditions under which it would scale back its buying, maintaining its bias to taper in the future:  “In judging when to moderate the pace of asset purchases, the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective…”

The Committee did not change the paragraph on thresholds at all. It simply restated the economic conditions it deems consistent with exceptionally low rates – a 6.5% or higher unemployment rate, 2.5% or lower one- to two-year ahead inflation projections, and well-anchored longer-term inflation expectations. We can expect that this forward guidance will be strengthened at some point, but perhaps not until tapering becomes more imminent.

It is tempting to think that, having surprised the markets with a “no taper” decision in September, the FOMC is poised to keep purchasing assets outright at the current pace for the foreseeable future (and beyond). But it is technically and politically difficult for the FOMC to keep purchasing $40bn/month in MBS and $45bn/month in Treasury securities. To maintain QE3 in its current form is to pursue an extremely aggressive easing policy in the face of expected improvement in economic fundamentals and appreciating risky asset markets.

The FOMC next meets on December 17-18. While there is some probability the Fed tapers QE3 before year-end, we believe the probability is small (about 10%). We, and presumably the FOMC majority, believe the government shutdown had limited long-term effects on real economic activity. But it will take weeks for the data to confirm that. Moreover, the quality of US economic data for October to be released in November and beyond may be compromised. The Bureau of Labor Statistics, for example, collected no electronic data in the entire first half of October for its monthly nonfarm payrolls survey. And the BLS household survey (which is used to calculate the unemployment rate, among other figures) was disrupted by the furlough of interviewers earlier this month. We also need to be mindful that while the government shutdown is over, potential for renewed fiscal fracas remains with the temporary nature of the government compromise (approving a continuing resolution only through January 15 and re-instating the debt ceiling on February 7) clouding the outlook.

Assuming the federal government averts another shutdown in mid-January (and deals with the debt ceiling without incident), there may well be a $10bn taper at the January 28-29 FOMC meeting, evenly split between MBS and Treasury purchases. But renewed fiscal crisis or a worsening of real economic data would likely delay the Fed’s first cutback in the pace of its asset purchases to March or later.

A scenario of two more evenly split $10bn taper moves in March and April, a $15bn taper in June (-$5bn MBS, -$10bn Treasuries), and then two evenly split $20bn tapers in July and September would end QE3 in September 2014, about a quarter later than envisioned by the FOMC back in June and under this scenario, QE3 will have totalled just over $1.65tn, more than double QE2’s $600bn and only about $70bn short of QE1, which expanded the Fed’s balance sheet by $1.725tn. Under these assumptions, the balance sheet will be about 60% larger a year from now than it was when QE3 commenced in September 2012.

Another possible scenario is that after reducing QE3 to about a quarter of its current size by next summer, the Fed may choose to continue small and variable asset purchases through year-end and perhaps into 2015. This would allow ramping up of purchases if more accommodation became necessary without needing to commence a ‘QE4’.

Alternatively, if economic data are stronger in the second half of 2014, but not robust enough for the Fed to consider hiking interest rates, asset purchases could be used to reduce the tendency for the front-end of the market to start pulling forward the presumed date of the first tightening. This has been an increased risk ever since the FOMC switched to threshold-based forward guidance from calendar-based guidance.

These are ideas that will no doubt be considered if and when Mrs Yellen assumes the chair, and she may well favour smaller, more frequent adjustments to policy than Mr Bernanke, who tended to favour large changes that then persisted for months.