- How will the Fed manage the exit process?
- There are two ways QE could come to an end
- We see QE tapering starting soon
Minutes from the October 29-30 FOMC meeting released last week included an unusual section titled “Policy Planning”—an indication of the many moving parts and difficult trade-offs in the Fed’s current communication framework. Before getting into the details, it’s worth pointing out that “policy planning” is just a euphemism for “exit strategy.” Chairman Bernanke walked through a variety of explanation for the persistent rise in the term premium in remarks on Tuesday. But he left out what we see as the most important one: that the Fed has turned its attention toward managing the exit process.
Relative to consensus views, the latest minutes expressed a cautious stance on the two main pillars of current policy: quantitative easing (QE) and forward guidance. First, the minutes acknowledged for the first time that the FOMC may choose to slow the pace of QE even if growth fails to accelerate. In effect, the minutes discussed a kind of QE decision tree—an idea we have written about before (see The Fed’s Decision Tree, Columbia Management Blog, October 8, 2013).
The document said the following:
“[Participants] generally expected that the data would prove consistent with the Committee’s outlook for ongoing improvement in labor market conditions and would thus warrant trimming the pace of purchases in coming months. However, participants also considered scenarios under which it might, at some stage, be appropriate to begin to wind down the program before an unambiguous further improvement in the outlook was apparent.”
Thus, there are two ways QE could come to an end: (1) growth conveniently picks up or (2) growth does not pickup, but the committee revises its views on QE’s costs, risks and efficacy. If the latter were to occur, the committee would need to decide how to communicate the change, and would consider offsetting the action by providing accommodation elsewhere, according to the minutes.
We continue to expect an announcement of QE tapering in the non-too-distant future, as we see the combined odds of these two outcomes as reasonably high. It is difficult to envision QE continuing at the current speed deep into 2014 if we see more of the same in the data—i.e. 2% growth and a slowly falling unemployment rate.
Second, the committee rejected two popular proposals for strengthening the forward guidance for the federal funds rate: lowering the unemployment threshold and introducing an inflation floor. The unemployment threshold idea had only “a couple” proponents, and the impact of the inflation floor was thought to be “uncertain and likely to be rather modest”.
The minutes reinforced our sense that any change in forward guidance will be qualitative rather than quantitative. This could take the form of explicit commentary on the labor force participation rate and/or guidance about the path for the funds rate after the 6.5% threshold is breached. The latter idea is appealing but we suspect that making projections about the slope of future rate hikes sufficiently credible will be a tall order.