Monetary policy

Yes, no tapering

At the FOMC meeting that ended on Sept. 18, the committee decided to maintain the current bond purchase program at the pace of $85B per month. The decision caught many people on the Wall Street by surprise and sent major stock indexes higher by more than 1%. Before the FOMC meeting, the market expectation was that the Fed would reduce the size of the bond buying program by $10B to $20B per month.

I am glad that I correctly predicted the tapering would not happen this FOMC meeting (I keep maintaining my position that the taper will start early next year). In my notes on Aug. 2 and Aug. 20, I pointed out some of my thoughts behind my predictions. Low growth, low inflation, reluctant government spending, and the fast increasing of U. S. treasury yield in anticipation of the Fed tapering were all factors that were covered in the Fed policy statement. The following paragraph is cited from this statement:

“Information received since the Federal Open Market Committee met in July suggests that economic activity has been expanding at a moderate pace. Some indicators of labor market conditions have shown further improvement in recent months, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has been strengthening, but mortgage rates have risen further and fiscal policy is restraining economic growth. Apart from fluctuations due to changes in energy prices, inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.”

I think there are several other factors that could have some impact on the Fed decision as well, although they are not covered in the Fed policy statement.

First, the recent increase in the yield of the U. S. treasury bond has prompted a large amount of capital outflow from the emerging market (EM). The capital movement put a lot of pressure on the currencies in the EM countries and their economies. Slowing growth in the EM could challenge sustainable U. S. economic recovery.

Second, there is a potential for fiscal discord in Washington. The U. S. government will soon reach its debt ceiling, facing potential government shutdown and suspending of certain payment.

Although no tapering, I think this FOMC meeting marked an important turning point for the Fed.

The Fed policy has been incredibly accommodative since the financial crisis. The so called communication tool the Fed adopted created a connection between the Fed and the market, by orchestrating a dancing between the two. The Fed cheers the market by giving what the market wants, and the market excites people and excites the economy.

Given a moderate economic recovery and sizable gain in the stock market, I think the Fed is no longer gauging the party should keep on and now it is the time to regain master control of its policies. Rhetorically the Fed sent that message to the market. “We can’t let market expectations dictate our policy actions,” Chairman Bernanke said at the news conference after the FOMC meeting, “Our policy actions have to be determined by our best assessment of what’s needed for the economy.”

The communication tool is phasing out. The Fed refused to give any clear path of the bond buying program. The policy statement only indicated that the Fed is watching carefully for the signs it needs to start pulling back. Chairman Bernanke isn’t committing to anything. “We are tied to the data,” he said, “We don’t have a fixed calendar schedule.”

In response to the financial crisis, the Fed has adopted four non-conventional monetary policy tools: the zero bound fund rate, the balance sheet approach (QE), the yield curve flattening (operation twist), and the communication tool. Operation twist has ended and now the communication tool is being withdrawn. Tapering the QE is again very likely to start early 2014 when a sustained recovery takes firm foot. Normalizing the Fed fund interest rate will be a topic after 2015.

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