Monday, June 17, 2013

FOMC Report June 18-19, 2013

FOMC Report

June 18-19, 2013

Martin McGuire

Ben Bernanke paid the price of admission for a view of what may happen when the Fed begins to reduce the level of additional support provided by the $85 billion in monthly securities purchased.  By indicating at a May 22nd congressional hearing the Fed could start reducing the amount of monthly purchases at one of its next few meetings if the economy continues to show improvement, Bernanke helped touch off a decline in equity markets and exacerbate a decline in the bond market that began in early May.   

Many suggest the Fed should get poor marks for communication, in part because of the response risk assets had to remarks made by Bernanke and other Fed officials about securities purchase prospects.  In less critical light, one might view recent Fed suggestions that a tapering of securities purchased may be forthcoming as an insurance premium paid against more shocking revelations later.  By prompting economic agents to adjust positions now, the Fed may be providing for more lasting stability through the upcoming period of ‘tapering’.       

The current Fed purchase program is far from being immediately retired.  However, just as additional support was provided initially by the fact that this program is open-ended, we can expect that a reduction to the current pace of asset purchases will prompt more exaggerated reaction than would have been the case in prior  close-ended, dollar specific purchase programs.   

Try as the Fed might to get the point across that the pace of asset purchases can vary in both directions depending on the progress of economic conditions, it will be difficult to convince economic agents once the purchase pace is slowed, of anything but continued and likely escalated pace reductions to immediately follow.   

Because the reaction to the news of tapering of the securities program could be severe, we should expect the Fed to take additional steps to reduce the prospects for unwanted market dislocation which could elevate systematic risk.  The Fed can provide some support against that which will be removed with tapering by issuing guidance that spells out a Fed intention to hold securities purchased to date for a lengthy period. 

A likely place to lay plans to hold portfolio assets is in the exit strategy the Fed has recently indicated needed revision.  It is difficult to imagine the Fed is prepared to show a revised exit strategy formula at this meeting and also move forward with initial tapering.  When the Fed begins tapering, I expect it will be a reduction of only $5 billion in both Treasuries and agency MBS and that it will be announced concurrently with revised portfolio holding plans.  I place a 20%, 60% and 20% chance for these developments at this and the next two FOMC meetings respectively.

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