Heightened uncertainty around quantitative easing is mostly a short run problem.
We see roughly flat odds of 20% for tapering at each of the next four meetings—December, January, March and April—and an additional 20% chance that the current QE pace continues beyond that.
We have turned modestly more cautious about interest rate risk in our portfolios.
One of the ironies of Ben Bernanke’s tenure is that he set out with a goal to improve Fed communication while in office. Immediately after his first meeting as chairman in March 2006, Bernanke set up a subcommittee tasked with facilitating debate around communication issues—including inflation targeting, the post-meeting statements and minutes, and public speeches by individual Fed officials.
As Bernanke prepares to step down, the view among most observers is that Fed communication is in disarray. Just a few weeks ago the vast majority of investors expected the FOMC to announce at its meeting that it would begin slowing the pace of QE. Now the consensus has swung to a March/April timeframe for tapering, despite little substantive news on the economy. This is a sure sign that something has gone wrong with official communication about policy.
Fortunately heightened uncertainty around QE is mostly a short run problem. Fed officials have offered few specifics about what signals would lead them to begin the tapering process. The one data point mentioned publically—a 7% threshold for the unemployment rate—was discarded by Bernanke at the September FOMC meeting press conference. At this point the tapering decision looks entirely discretionary to us, and we have very low confidence about the exact timeline. We see roughly flat odds of 20% for tapering at each of the next four meetings—December, January, March and April—and an additional 20% chance that the current QE pace continues beyond that.
We have more conviction about where Fed policy is headed over the next six to 12 months. The initial talk of tapering this summer started for two specific reasons: (1) the economy has made progress towards achieving the Fed’s goals, and (2) several years of balance sheet expansion caused policymakers to begin asking questions about QE’s costs, risks and efficacy. Although the timing is uncertain, these same two factors should lead to a pullback in QE in the not-too-distant future.
First, Fed officials are unlikely to ignore the drop in the unemployment rate entirely. Although they have emphasized that other labor market indicators are important as well, the unemployment rate still plays a prominent role in debates about U.S. monetary policy. As Yellen herself noted in a speech earlier this year: “Federal Reserve research concludes that the unemployment rate is probably the best single indicator of current labor market conditions. In addition, it is a good predictor of future labor market developments.” (March 4, 2013). Both the current guidance for the funds rate and the Fed’s formal statement on long-run goals and objectives are written in terms of the unemployment rate. Many of the monetary policy models used at the Fed and in academia are also centered on the jobless rate. It will be tough for current policymakers to shake off this institutional legacy.
Second, if growth fails to accelerate, even strong supporters of QE might begin to question its efficacy (see our earlier comment on this point). In our view, there are practical and political limits to the size of the Fed’s balance sheet, and these might start to bind if the program is running at $85bn per month through the middle of 2014.
Long-term interest rates have retraced a significant part of their increase to early September—approximately 50bp for the 10-year Treasury. At current levels yields are now below our rough estimates of fair value. Given current views in the market about the economy and Fed, we think investors could be surprised by how quickly QE tapering talk returns. We have therefore turned modestly more cautious about interest rate risk in our portfolios.