The Fed Tries to Clarify While Holding the Line (Sorensen)

June 19, 2013

by Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research

Key Points

• The Federal Reserve made no changes to monetary policy, despite chatter that it may begin to reduce asset purchases. The economic outlook was upgraded modestly, but the target interest rate remains near zero and asset purchases will continue at $85 billion per month.
• Chairman Ben Bernanke attempted to clarify the central bank's thinking about how and when it will start to scale back on asset purchases. He emphasized that the Fed has flexibility to add or reduce purchases as necessary, and that future action will be data-dependent.
• Increased communication from the Federal Reserve may not be having the impact Chairman Bernanke hoped for. Regardless, it appears tapering will begin later this year, but we remind investors that a reduction in asset purchases does not constitute tighter monetary policy.

Despite growing investor concern over "tapering," the Federal Open Market Committee (FOMC) kept monetary policy as is, but did outline how asset purchases may be scaled back if the economy progresses as expected. The Fed will continue to purchase $40 billion per month in mortgage-backed securities, while also purchasing $45 billion in longer-term Treasury securities. The target range for the fed funds rate will remain at 0–0.25%, and the Fed continues to believe that rate will be appropriate "at least as long as the unemployment rate remains above 6.5%." It acknowledged a "modest pace" of economic expansion, noting that the labor market is continuing to show improvement (however, the unemployment rate remains elevated). Inflation has been running below the Fed's longer-term objective and inflation expectations remain stable. The Committee did upgrade its economic assessment modestly by noting that "downside risks to the outlook….hav[e] diminished since the fall."

The Federal Reserve has been publishing its forecasts for economic growth, inflation and unemployment for some time now, and updated those projections today with slight upgrades to both the unemployment and economic outlooks.

During the press conference that followed the releases, Chairman Bernanke outlined the possible path a tapering program could take. If the economy develops as the Fed expects, asset purchases would start to be scaled back later this year and would likely end by the middle of 2014. He emphasized that the central bank will be watching the data closely and staying flexible on policy. Even once a "tapering" process has started, it could accelerate, stop, or reverse depending on developments in the economy.

Is the expanded communication helping?

As evidenced by the increased chatter by Federal Reserve members in between meetings, and the addition of a press conference by the Chairman after alternate meetings, a focus of Bernanke's chairmanship has been to increase transparency of the central bank's thinking. His belief is that by dropping the veil that had surrounded the Fed for so long, markets would be better able to react to monetary policy, thereby reducing volatility and uncertainty in the market.

But as most have learned, sometimes it's better not to see how the sausage is made!

It would be difficult to argue, after the past several weeks of market action—ever since Bernanke's testimony before Congress in late May—that volatility related to Federal Reserve actions has been reduced greatly. It might be argued that uncertainty has actually increased. With more Fed members than ever before speaking about monetary policy in public, markets are trying to judge which comments to take more seriously and how to react to them.

The fact is that the Federal Reserve remains unable to divine the future, much like the rest of us. It depends largely on developments in the economy to determine action—as it should. But, in our view, publicizing diverging current opinions and making specific economic predictions two years or more into the future is a tough game to play—and risks hamstringing the Fed when action may be necessary.

Having said that, the recent communication and the Chairman's press conference today lead us to believe that a slow reduction of the pace of asset purchases is likely to start later this year, probably in September. Chairman Bernanke's testimony before Congress was likely a somewhat clunky way of trying to prepare the markets for that possibility. Recent FOMC statements have emphasized flexibility, but it seems clear that a growing number of members believe the time has come to pull back on the asset purchases. Unemployment has dropped and jobs are being added at a decent, if albeit modest, pace; the sequester doesn't seem to be having a major impact on growth; housing has improved substantially; and the American consumer has remained resilient—setting the stage for a long, slow return to somewhat normal monetary policy.

The first step of that journey will be to reduce and eventually stop the asset purchases. And while it's been a rough ride for several weeks, the market has been preparing for that eventuality, and will have at least several more weeks to adjust to that idea. By the time an announcement is made, it's likely that markets will have already recalibrated themselves. However, it remains a delicate balancing act for the Fed to retain flexibility but provide some measure of certainty to the markets with regard to the pace and timing of the tapering. We'll be watching the process with great interest.

As a final note, and as Chairman Bernanke emphasized today, scaling back on asset purchases is not the same as monetary tightening. The FOMC believes its target rate will hold until well into 2015. Its potential actions are a result of improving economic conditions, and investors who need to add to equity positions can use these pullbacks to do so.

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