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Monetary policy

Fed QE exit strategy

The FOMC meeting that ended on December 18 spelled out the strategy of exiting the large assets purchase program (QE) — initially reduction of $10B out of $85B monthly purchases from January and further reduction dependent on economic data. To dampen the reaction from the market participants, the Fed sweetened forward guidance of federal funds rate and extended ultra low rate well beyond 2015.

Both forward guidance for the federal funds rate and large scale asset purchase program are aimed to hold down the longer-term interest rates, but they affect longer-term rates through different channels (see reference [1]). Longer-term interest rates are affected by two components. One component reflects the expected path of short-term interest rates, and for that the Fed uses forward guidance for the federal fund rates to influence market participants.

The second component is called a term premium. The term premium is the extra return that investors require to be willing to hold a longer-term security to maturity compared with the expected yield from rolling over short-term security for the same period (reference [1]). The large scale assets purchases most directly affect term premium.

After reading the FOMC release, I had two strong feelings. First, I think the Fed aims to keep pushing down longer-term interest rates while returning the federal fund rate as the primary tool for monetary policy. Second, I think the Fed is striving to protect the equity market in the course of normalizing the monetary policy.

References:

[1] Ben S. Bernanke, Communication and Monetary Policy, November 19, 2013.

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