Ignore the Taper, Focus on Forecasts
Today may mark the beginning of the end of the Federal Reserve's bond-buying. That's less of a big deal than you might think.
While announcements about asset purchases will be important insofar as they reveal the Fed's evolving priorities and read on economic conditions, analysts will be better off focusing their attention on the Fed's updated economic forecasts, as well as on any statements about the future path of short-term interest rates.
For one thing, interest rates have already moved tremendously in anticipation of "the taper," so it isn't clear why explicit confirmation of what everyone was expecting should have a big impact. One explanation for this shift is that the Fed started publicly expressing concerns about the negative side effects of its programs.
It was only a few months ago that concerned observers, including me, were worried that the Fed was attempting to revive the economy by inflating new bubbles in risky debt. Times have changed a lot since then. Interest rates are up, hot money has fled many emerging markets, and some are worrying that the feeble U.S. recovery has been endangered by higher mortgage rates.
As Vince Foster noted at Minyanville, the Fed began experiencing "buyer's remorse" as early as the end of January, when the minutes reveal that they asked the staff to study the possible costs of unlimited asset purchases. The gold/dollar exchange rate was the first victim of this "tightening" of Fed policy.
At the end of May, Ben Bernanke, the Fed's chairman, testified on the possibility that the U.S. central bank would "taper" its bond-buying programs before the end of the year because he and his colleagues were concerned about "financial instability." Then, at the June 19 news conference, Bernanke explained that the Fed expected asset purchases to have completely stopped by the time the unemployment rate had reached 7 percent. That's well short of the Fed's estimate of the "natural rate" of joblessness, which is between 5.2 and 6 percent.
People at the Fed and in academia don't seem to see things this way. Their latest research argues that asset purchases are relatively ineffective at stimulating the economy, especially when compared with "forward guidance" about the future path of short-term interest rates. This finding has been supported by top academics who presented at the Fed's big retreat in Jackson, Wyoming, both this year and last year, although there is some disagreement about the extent to which purchases of mortgage bonds are qualitatively different from purchases of U.S. Treasury debt.
When I interviewed Columbia University's Michael Woodford (one of the fathers of "forward guidance") last week, he explained that the Fed was rightly concerned that the benefits of bond buying were close to being outweighed by their costs. According to him, the Fed should stop asset purchases altogether and focus exclusively on articulating when and why it will raise short-term interest rates from their current low levels. The Fed started moving in this direction back in December, when it announced that it would not raise short rates as long as the unemployment rate was above 6.5 percent and the near-term forecast for inflation was slower than an annual rate of 2.5 percent.
This policy shift toward "forward guidance" makes the forecasts of economic activity all the more important for traders. One reason that interest rates spiked on June 19, especially in the three- to five-year range, was because the Fed's forecasts for unemployment had become relatively more optimistic. Some analysts think that the Fed will attempt to offset the impact of any cutback in asset purchases by altering the thresholds for rate increases. The net effect could actually end up lowering borrowing costs, despite all the hoopla about "tapering".
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