Uncertainty over Syria, debt ceiling negotiations, low inflation and even the August employment report is likely to see the Fed opt for a smaller pace of tapering at the Sept 17/18 FOMC meeting.
A US$5-10bn taper would help risk markets as it will send a signal that a more cautious Fed will not be quick to pull the trigger when it comes to eventually hiking the Fed Funds rate.
The Fed has done a lot of work in adjusting market expectations toward an early start to tapering. According to the latest NY Fed’s Primary Dealer survey the expectation is that tapering will start with a US$15bn reduction at the September meeting.
If the Fed failed to taper QE then this would muddy the waters in terms of timing but could see markets price in a faster pace of tapering and a smaller lag to any subsequent rate hike.
Getting the first taper out of the way on Sept 17/18 but pointing to subsequent moves being data dependent is likely to prove a more optimal strategy. A reduction in QE of US$5-10bn would also help to provide the Fed with flexibility given uncertainty over Syria, budget negotiations, low inflation and employment outlook.
But with an end to tapering focused on mid-2014 the focus from the FOMC will shift toward trying to disconnect the outlooks of unconventional policy from conventional policy.
We are already seeing a shift in emphasis with Fed’s Evans (of the Evans rule that eventually gave us numerical thresholds) saying last week that he could “easily envision certain circumstances in which the unemployment rate could go below 6 percent before we moved the funds rate up”.
Tapering will increase the importance of the forward guidance language as the Fed looks to communicate that an end to QE does not mean rate hikes are automatically around the corner.
Risk markets will be soothed by a Fed that tapers to the tune of US$5-10bn as well as a desire to reinterpret the forward guidance language to signal that rate hikes will happen later.