Divyang Shah, Senior IFR Strategist
Ever since the Fed started us on this road toward tapering QE the market has found it difficult to see why:
1) removing accommodation by tapering and ending QE will not also mean that the Fed will also want to raise rates early
2) if the Fed itself sees unemployment between 6.5-6.8% in 2014 then the risks of early rate hikes need to be priced by forward looking markets.
Since the FOMC meeting several Fed speakers have attempted to point markets in the right direction but with little effect.
Bernanke has now adopted a different tact by highlighting the data dependency of tapering QE as well as reinterpreting the numerical thresholds for raising the Fed Funds rate.
In sum, the hope is that there is enough here for markets to factor in a less steeper and later tightening cycle. On the QE outlook we had Bernanke highlight a lot of well known downside risks (fiscal policy and slower global growth), both support the view that asset purchases are not on a “preset course”.
But the bigger changes came in the way in which the Fed now views its numerical thresholds by:
1) reiterating that unemployment can fall below 6.5% before the Fed Funds rate is raised, and
2) low inflation is given a slightly higher weight and no longer seen as being a short term phenomena.
The objective is to clearly highlight that QE is not on autopilot and the uncertainties also mean that the outlook for interest rates is also less certain.
Overall we don’t see the testimony as diminishing the chances of the Fed tapering QE at its September FOMC meeting. But it does mean that what happens beyond here is less certain with the Fed likely to pause in October before continuing to taper at the December FOMC meeting.
Pausing would allow the Fed to gauge the impact of tapering as well as the fiscal policy outlook but it would also help to add credibility to the view that if the tapering road is uncertain then an end to ZIRP is some distance away.
