FOMC Meeting: What Happened?
Markets are reacting to the Fed's first "tap on the brakes". The fear among market participants is that once the Fed begins to cut its current asset purchase program – which is still a hypothetical development, depending on future economic data – it will be just the first step toward normalized (higher) short-term interest rates.
The official written statement from the Federal Open Market Committee (FOMC) meeting was mostly status quo in that policy actions (Fed Funds target rate and continuing the large-scale asset purchase program) are the same as before. It reiterates in exactly the same language as the last FOMC meeting statement that current policy will continue "until the outlook for the labor market has improved substantially in a context of price stability". However, they released an updated economic forecast with a somewhat improved projection for unemployment and less downside risk for the economy compared to the March forecast. The new forecast projects weaker growth for 2013 than the March forecasts, but stronger growth in 2014 and 2015. It also shows a lower projection for inflation for 2013 (0.3% lower), 2014 (0.2% lower) and 2015 (0.1% lower) than the previous forecast. The Fed's new forecast is more optimistic than private forecasts and contains projections that are not visible in the current economic data.
Bernanke elaborated on the outlook for policy in response to questions at the press conference. Consistent with the previously articulated policy, the improved economic forecast implies that the Fed could begin reducing ("tapering") the asset purchase program before the end of this year and stop it altogether by the middle of next year if the economy performs according to the Fed's forecast. (He also said that they could pick up the pace of bond purchases again if the economic data weaken.) While the Fed staff and policymakers actually analyze a lot of different measures of the economy, for the purposes of articulating policy to the public they specify "performance" as a mix of the unemployment rate, realized inflation and inflation expectations. In particular, completely stopping the asset purchase program assumes that the unemployment rate will fall to about 7% by the middle of next year and inflation is near their 2% target (Core Personal Consumption Expenditure price index). If any of those fall short, tapering could be postponed.
Tapering is unlikely to start before the fourth quarter due to the Fed's deliberative process for weighing economic statistics and waiting for confirmation before making a policy change. If this optimistic forecast does not pan out, they can resume (or even increase) the full amount of asset purchases. The paradox in the policy is that several of the areas of the economy that are currently performing well are quite interest-sensitive, such as automobile sales and construction. If the market continues to push interest rates higher in anticipation of future Fed stimulus reduction, the economy could slow and force a delay.
So far, TIPS appear to be mainly moving with nominal Treasury market yield changes, which are being driven by short-horizon risk reduction. Once that runs its course, the economic data will likely be scrutinized for evidence that the economy measures up to the Fed's new forecast. With 10-year Break-even Inflation rates at about 2.05%, near the 2% low for 2012-13, TIPS may be well-priced compared to nominal bonds as of this writing.Definitions
TIPS - Treasury Inflation-Protected Securities (TIPS) are the inflation-indexed bonds issued by the U.S. Treasury. The principal is adjusted to the Consumer Price Index (CPI), the commonly used measure of inflation.
FOMC - The Federal Open Market Committee (FOMC) is the branch of the Federal Reserve Board that determines the direction of monetary policy.
CPI - Consumer Price Index (CPI) is a measure used to assess price changes associated with the cost of living. The return of Treasury Inflation Protected Securities is linked to the rate of U.S. Inflation as measured by the CPI.
CPCE - Core Personal Consumption Expenditures index measures price changes in consumer goods and services, excluding seasonal food and energy prices.
BEI - Break-even inflation (BEI) is the difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality.
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