Fed continues with tapering plans, adapts forward guidance

At its policy meeting on 19–20 March, the Federal Open Market Committee (FOMC) announced that it would continue winding down its asset purchase program at the pace it announced in December. The Fed explained that given the, “cumulative progress towards maximum employment and the improvement in the outlook for labor conditions,” it has decided to, “make a further measured reduction in the pace of its asset purchases.”

Starting in April, the Fed will conduct purchases of USD 30 billion of long-term Treasury securities and USD 25 billion of mortgage-backed securities per month, down from USD 35 billion and USD 30 billion respectively. This cumulative USD 10 billion reduction equals that which was implemented following the two previous meetings. If the winding down of asset purchases continues at the current pace, the program would end towards the end of this year. The Fed expects that maintaining a portion of the original purchase program will continue to promote economic recovery.

According to the Fed, growth in economic activity was hampered in recent months due, in part, to harsh winter weather. In terms of the labor market, the Fed pointed out that indicators are mixed and the unemployment rate remains elevated. However, the Fed considers there to be, “sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions,” and will continue to monitor economic developments. If there are indeed further improvements in the labor market and if inflation continues to move towards it long-run objective, the Fed, “will likely reduce the pace of asset purchase in measured steps at future meetings.” However, the Fed reiterated that asset purchases are not on a “preset course” and its decisions remain contingent upon sustained economic improvements.

Meanwhile, in order to support continued progress in the economy, the FOMC announced that the federal funds target rate would remain within the current range of between 0.00% and 0.25%. However, the Fed revamped its forward guidance regarding this low target range. Specifically, it stated that future decisions to hike the rate no longer depend on the previously-established threshold of 6.5% unemployment, but rather on the assessment of a, “wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.”

Moreover, the Fed indicated that it would likely be appropriate to maintain the current low target range for the federal funds rate for, “a considerable time after the purchase program ends.” The Fed currently anticipates that economic conditions will warrant keeping the rate at low levels, “even after employment and inflation are near mandate-consistent levels.” In the press conference that followed the announcement, Fed Chair Janet Yellen vaguely suggested that a rise in interest rates could come in, “something on the order of around 6 months,” after the conclusion of the bond buying program, which would be in the middle of 2015. However, Yellen couched this statement with many caveats, emphasizing that they will be tracking a variety of indicators before making any decisions.

The transition from a quantitative metric to a broad qualitative guidance scheme has generated some uncertainty among investors and market analysts, many of whom are not convinced by the Fed’s claims that the overhaul, “does not indicate any change in the Committee’s policy intentions.” Rob Carnell, Chief International Economist at ING, says:

So after all the months of “forward guidance” and focusing on transparency, the Fed now seems to have realized that when you can’t forecast the variables you want to with any reliability, a bit of vagueness and obfuscation can help you to pursue your policy objectives without as much criticism from market observers as has recently been the case.

The lack of clarity has led some to turn to the projections made by committee members in a supplementary document in search for quantitative guidance. The median projection is for rates to rise to 1.0% by the end of 2015, which is up from the 0.75% median estimate made in December. Despite Yellen’s attempts to downplay the importance of these forecasts, analysts have interpreted them as a sign that the Fed’s low rate policy is going to change sooner than expected. Harm Bandholz, Chief U.S. Economist at UniCredit, says:

While the magnitude of the forecast change is still very small, the direction is noteworthy, as it is the clearest sign yet, that the tendency for later and later rate hikes that dominated over the past couple of years might have come to an end.

FocusEconomics Consensus Forecast panelists expect the Fed to keep interest rates unchanged in 2014. Next year, the panel sees the federal funds rate averaging 0.73%.

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