Tuesday, September 17, 2013

FOMC Report September 17-18, 2013

A Face-lift for Fed Guidance: 

Fed guidance to this point has been considered largely to refer to communication about the timing and pace of adjustments to the Federal Reserve fed funds ‘policy rate’ from its current zero bound.  Fed officials have become increasingly aware of the power of this form of communication and may soon begin to use guidance on a variety of policy tools.  

At the September 2012 FOMC meeting, the Fed chose to begin its latest LSAP program (QE3) with the open-ended purchase of $40 billion per month of agency mortgage backed securities.  Even though this was meant to be a powerful step toward greater accommodation the Fed decided to offer additional support through guidance by extending the likelihood for fed funds resting at the zero bound until mid-2015 from late-2014.  

The additional guidance on fed funds policy outlook further strengthened the commitment toward an accommodative policy.  The greater benefit from this guidance however, was in describing the location for fed funds for an additional 6 months rather than the commitment to a low rate, thus potentially reducing the term premium.  Term premium is pressured by expectations for a low variance of short rates rather than the short rate being at a low level. 

At the December 2012 FOMC meeting the Fed once again added to the level of accommodation by including Treasury securities to its open-ended purchase program.  The Fed also once again altered its guidance, this time by describing with threshold parameters the prospects for policy rates held at the zero bound.  Interestingly, even though the Fed’s intent was to bring greater clarity to the process by which the policy rate might be increased, by indicating, ‘The Committee views these thresholds as consistent with its earlier date-based guidance.’, the calendar length of guidance since September had been reduced by 3 months.     
Finally, while it was intended to secure an understanding that policy rates would remain low until their dual mandates were in sight, threshold guidance added variables to the equation for when policy rates may change, thus increasing at least temporarily, uncertainty about forward rates. 
As time has passed, December economic projections proved to be a tad optimistic.  Recently slower sales, employment , output  and confidence data has left many to believe the Fed will again lower its forward growth projections in the upcoming Summary of Economic Projections (SEP).    

Any Recognizable Path in a Storm:

If Fed guidance is to work as support to economic growth it needs to allow economic agents to form expectations for a relatively narrow path for policy rates over an extended period.  All economic agents need not agree about the likely path for policy rates, but a majority of these agents must be induced to subscribe greater confidences in path expectation for term premium to be reduced.  Reduced term premium in turn lowers the hurdle rate for all economically viable enterprise.    

Recently, term premium has again risen and extensive volatility has attended economic reports.  Market volatility around economic reports is consistent with the uncertainty regarding tapering prospects. Volatility in short-term rate has likely helped push term premium higher.  There is clearly room to benefit from additional guidance at this juncture.  

The Fed would rather not adjust the threshold guidance or return to a calendar date reference for low policy rates.  The July FOMC minutes made it fairly clear; ‘ In general, there was support for maintaining the current numerical thresholds in the forward guidance.’  There has been some talk however of possibly reducing the threshold for unemployment from 6.5% to 6%, but a few participants expressed concerns noting; ‘a decision to lower the unemployment threshold could potentially lead the public to view the unemployment threshold as a policy variable that could not only be moved down but also up, thereby calling into question the credibility of the thresholds and undermining their effectiveness.  Others have suggested a lower bound for inflation be added to prove resolve.  This however would also likely undermine the effectiveness of threshold guidance. 

There is room to add guidance to balance sheet prospects.   When the Fed simply starts the tapering process, market participants will be able to form, at a minimum, a loosely constructed path for the termination of additional purchases.   Even though the Fed will warn there is no pre-determined path for the elimination of LSAP, uncertainty will diminish as economic agents script those schedules.  The gain to economic growth and possibly lower risk premium from this new understanding for the path of tapering will likely outweigh the marginal benefit from the lost securities additions.    

Additionally, the Fed could offer guidance as to the likelihood for the holding period for the balance sheet.  This could also work to lower the term premium as it would reduce concerns for market volatility resulting from asset sales until a distant point in time (if ever).  

It has not been since mid-2014 that the Fed has turned from the direction of only additional levels of accommodation.  A move toward adjusting lower a level of purchases is not itself a tightening.  It is however a move away from a higher level of accommodation.  The open-ended nature of the existing LSAP gave a greater level of importance to this current program.  As such, the tapering of this program may also involve a greater psychological impact. This may be reason enough to prompt the Fed to give some form of additional guidance when announcing the initiation of tapering.   

Cost of Insurance:

The Fed took out a form of insurance when it telegraphed its intention to begin lowering the level of asset purchases.  The reaction to this message was dramatic and at the time I generously likened it to a premium payment for volatility insurance down the road for when the Fed actually began to taper.  Large adjustments have been made to portfolios since this time and there is a real chance that the reaction to an announced tapering schedule at this juncture will be met with limited volatility.  

However, the time between Bernanke’s May 22 Congressional testimony where he first indicated tapering was forthcoming and today has seen increasing levels of volatility surrounding economic reports.  Market participants felt each report had the potential to change the timing of the tapering schedule and thereafter, however ill-conceived, the timing of the lift-off of policy rates from the zero bound.  To delay further the initiation of tapering would prompt additional questions of when the tapering may begin and each economic report will be a source for additional volatility.  

It is a shame that the economic data has not been robust enough to find a super-majority expecting a tapering announcement on Wednesday.  However, some of the reason for the lack of economic progress over the last 12 weeks may have much to do with the unfinished business begun on May 22nd and the uncertainty surrounding the when of tapering.   

The Fed has done a pretty good job of indicating they intend to begin reducing the level of securities purchased by the end of the year.  The level of volatility surrounding data prints and the decreasing efficacy of the purchase program should outweigh any reluctance to taper based on concern for recently weaker than forecasted data.  Especially considering this weaker data may be in response to the uncertainty regarding the timing for the beginning of tapering.  

Congratulations to those who saw as far back as June the likelihood for the Fed to wait till September to begin tapering.  Some of those who more recently saw September as a likelihood have moved those expectations from as far out as December.  Back in June I had ascribed a rather smaller chance that the Fed would have waited to this point to begin the tapering and it appears as if the economy may have suffered from the additional volatility the delay has caused.   

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