In the press conference following last weeks FOMC meeting, Federal Reserve (the Fed) Chairman Bernanke said that the committee was “puzzled” by the sharp rise in bond yields over the last two months, and that the increase “seems larger than can be explained by a changing view of monetary policy.” We would argue, in contrast, that the recent increase in bond yields has been almost entirely about a changing view of monetary policy. It’s true that the modest changes in the path for the balance sheet that the Fed is considering would have only a limited impact in any economic model. However, we see something much bigger underway. Recent Fed communication—especially Bernanke’s recent testimony before Congress and his press conference last week—has removed any doubt that the long monetary exit process has begun. For markets, this signal carries much more weight than the small changes in the pace of bond buying.
For interest rate markets, the tapering trade is probably now over. For the last few months, Fed watchers have been debating when the committee would signal a slowing in the pace of quantitative easing (QE). Although expectations had been shifting toward earlier meetings, as of the first week of June two thirds of economists still expected QE tapering to begin at the October FOMC meeting or later (Bloomberg survey). After last week’s FOMC meeting, we would guess that the consensus now expects tapering to begin at the September meeting. In addition, because Bernanke was so explicit about the outlook for QE—he stated that it would begin later this year and the program would end in mid-2014—the tapering debate will not likely remain the key driver of bond yields going forward.
Why were Fed officials and the market consensus so far apart on the QE outlook? Based on what we heard, we see three candidate explanations.
First, Fed officials have an optimistic take on recent growth news. In particular, they believe that fiscal policy is currently a major drag on economic performance. Therefore, the fact that U.S. growth has remained roughly steady at around 2% implies that underlying private sector performance looks considerably better.
Second, Bernanke and others are looking through the low inflation news, in part because of technical factors. The Fed uses the “core PCE deflator” as its main measure of inflation. But just like all price indexes, the core PCE has certain flaws. Currently, core PCE inflation is running very low because of a high weight in medical care products as well as so called “non-market goods.” Chairman Bernanke noted in the press conference that low inflation in these areas is probably not very meaningful from an economic perspective. Higher inflation in other price indexes may also give the Fed some comfort.
Third, the Fed sees various costs and risks associated with QE. This was first signaled by Fed officials back in January but many market participants downplayed the discussion. Bernanke was pretty clear: “Asset purchases are a different kind of thing. They are unconventional policy. They come with … certain risks and certain uncertainties that are not necessarily associated with rate policy.” Dialing back the pace of QE does not mean they are entirely satisfied with the state of the economy—indeed, the unemployment rate remains well above the Fed’s estimate of its natural rate. But from a cost/benefit perspective, it might make sense to reduce QE a bit sooner.
From here the Fed’s exit strategy will depend on the economy. If growth disappoints or inflation falls further they might reverse course, increasing the pace of QE or pushing out the date of the first rate hike. In our view, however, growth will likely continue, and may even exceed consensus expectations this year. This should keep the monetary exit process in train and rates on a gradually rising trend.
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