From the February 2014 issue of Futures Magazine • Subscribe!

Unwinding quantitative easing and beyond

Provided the economy performs as well as Federal Reserve policymakers expect, the Fed will phase out large-scale asset purchases within the next 10 months. That’s a big “if” of course. The Fed has been projecting a stronger recovery each of the last four years, only to see growth average around a tepid 2%. 

This time, officials are more confident than ever that prospects for stronger growth are real, which is why the Fed’s policymaking Federal Open Market Committee (FOMC) began scaling back its third round of quantitative easing on Dec. 18, 2013 — cutting monthly purchases of longer term Treasury and agency mortgage-backed securities from $85 billion to $75 billion. 

In their revised projections, FOMC participants look for real GDP growth of 2.8% to 3.2% in 2014 and for faster 2015 growth.  

The unemployment rate is projected to fall from 7% as of the meeting to between 6.3% and 6.6% by the fourth quarter — well below the level at which then-Chairman Ben Bernanke estimated QE3 would end last June and close to the 6.5% threshold at which the FOMC had said it would consider raising the federal funds rate from near zero. Inflation is projected to move back toward the 2% target. 

The tapering decision, which came earlier (and later) than some predicted, followed a series of stronger employment reports that saw non-farm payrolls growing around 200,000 per month, and perhaps as importantly, a budget agreement being reached. Financial stability risks also were discussed, FOMC minutes show, but were a much smaller factor than progress toward the goal of “substantial improvement” in the labor market outlook established when QE3 was launched in September 2012.

As San Francisco Federal Reserve Bank President John Williams says, last September was “a close call,” but “by December, the economy was growing pretty well, adding a lot of jobs, the inflation data had  bottomed out and if anything there seemed to be some normalization of inflation trends, and the uncertainty and downside risks to the outlook were less.” 

The minutes say, “Most members agreed that the cumulative improvement in labor market conditions and the likelihood that the improvement would be sustained indicated that the Committee could appropriately begin to slow the pace of its asset purchases...”

Not only did the FOMC reduce bond buying, it served notice it “will likely reduce the pace of asset purchases in further measured steps at future meetings.” 

Although the FOMC statement said asset purchases are “not on a preset course,” and although Bernanke told reporters the Fed could stop or even reverse tapering if necessary, that is not the most likely outcome — even if growth falls a bit short of 3% temporarily. 

Federal Reserve bank presidents on opposite ends of the policy spectrum assertively endorse uninterrupted reductions in bond buying. 

No one was surprised when Richmond’s Jeffrey Lacker said “the data would have to be much weaker on a sustained basis to want to pause tapering” or when Philadelphia’s Charles Plosser said “the threshold would be pretty high” to stop tapering. But it was more eye-opening when San Francisco’s John Williams, former top advisor to new Fed Chair Janet Yellen, said he expects “steady, measured reductions” in asset purchases at each FOMC meeting and said it would take a “significant deviation” from FOMC forecasts for it to change course. 

Even Boston’s Eric Rosengren, who voted against tapering, conceded a pause is unlikely: The FOMC could slow or even reverse tapering if the jobs market “deteriorates substantially” or financial conditions unduly tighten, but “right now, it looks like the economy is improving at a pace that some gradual reduction in accommodation would make sense...” 

Equally striking, reputed super-dove Yellen, who succeeds Bernanke Feb. 1, voted with the majority. And Bernanke said “she fully supports what we did today.” 

So, unless the economy sinks into some new torpor for whatever reason, the FOMC likely will keep cutting asset purchases by $10 billion at each of the January, March, April, June, July and September meetings. That would leave $15 billion of QE3 remaining, which the FOMC presumably would negate Oct. 29, economic and financial conditions permitting. 

It is possible the FOMC could increase or decrease the size of cuts, but that would be a deviation from the predictable, “measured” pace envisioned and introduce needless uncertainty into markets. It also could vary the proportions of asset purchases, but it seems more likely the Fed will make equal cuts in Treasury and MBS purchases. 

Of course, as Williams says, ending QE will be just a “first step toward eventually bringing monetary policy back to a more normal setting.” The FOMC vows to keep monetary policy “highly accommodative,” and Bernanke says the Fed will provide monetary stimulus “as long as needed” to push unemployment toward its longer term range of 5.2% to 5.8%. 

Twelve of 17 FOMC participants see no rate hike until 2015, three none until 2016. With unemployment projected to fall below the 6.5% threshold this year, the FOMC amended its “forward guidance” to say “it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6.5%, especially if projected inflation continues to run below the Committee’s 2% longer-run goal.” 

However, if the economy does as well as hoped, pressure will mount to start actually tightening monetary policy earlier than now anticipated. Deciding when and by how much to hike rates may be Yellen’s first big test.

Steven K. Beckner is senior correspondent for Market News International. He is heard regularly on National Public Radio and is the author of Back From The Brink: The Greenspan Years (Wiley).

About the Author
Steven K. Beckner

Steve Beckner is senior correspondent for Market News International. He is heard regularly on National Public Radio and is the author of "Back From The Brink: The Greenspan Years" (Wiley).

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