 | A Dovish-Bullish Taper |
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| Posted Under: Government • Research Reports • Fed Reserve |
They finally did it. At Chairman Bernanke's next to last meeting, the Federal Reserve announced a modest tapering of quantitative easing, reducing its monthly purchases of Treasury securities and mortgage-backed securities by $5 billion each ($10 billion total) to $75 billion starting in January. As a result, the size of the Fed's balance sheet will continue to rise, but slightly more slowly than before.
Slowing the pace of QE was not the only change by the Fed, which issued a statement that was, simultaneously, more bullish about the economy and more aggressive about keeping short-term interest rates near zero.
Notably, the strong positive equity market reaction to today's announcement severely undermines the argument that it was QE supporting the stock market the past few years. Expectations about the amount of any remaining QE are clearly lower today than they were yesterday, and yet stocks are up substantially. If QE was supporting equities, less QE should mean a lower stock market, not higher.
The Fed said today that if the economy continues to behave as it expects, with an improving labor market and inflation moving toward 2%, that we should expect further tapering in QE in "measured steps at future meetings." In theory, with eight meetings in 2014 and QE starting the year at $75 billion per month, the process of eliminating QE could take all year. However, given the First Trust economic forecast – real GDP growth of about 3% next year with inflation of about 2% – we anticipate that QE will end around mid-2014.
The more bullish language in today's statement included more direct language on expanding economic activity, an acknowledgement that unemployment "has declined," and a comment that the (supposedly) negative effects of fiscal policy "may be diminishing." The Fed also said the risks to the economic outlook have "become more nearly balanced." Prior statements emphasized downside risks to the economy, although less so at the last meeting in October.
Despite more bullish language on the economy, the Fed added a new sentence to its statement, saying it now foresees the federal funds rate staying near zero "well past the time that the unemployment rate declines below 6.5%." The Fed also added language making this commitment even more important if inflation remains below 2%.
The one dissent at today's meeting was by Boston Fed Bank President Eric Rosengren, who did not want to taper at this meeting and is still concerned about elevated unemployment and inflation too far below 2%. Kansas City Fed President Esther George, who had dissented at prior meetings because monetary policy was too loose, voted in favor of today's Fed statement.
As we have written before, QE, by itself, has not boosted economic growth or equity prices. Instead, it has simply added to enormous excess reserves in the banking system. The Fed has used QE as way to signal keeping short-term interest rates low. Now the Fed has evidence it can generate this signal without QE. Expect less and less QE as we move into 2014, even as equities keep trending higher.
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