The Beginning of the End for Quantitative Easing

In his final press conference, Federal Reserve Chairman Ben Bernanke announced and explained the plan to end the quantitative easing, beginning with a $10 billion reduction in the pace of asset purchases.  This policy action is something of a fitting end to Bernanke’s tenure, as it marks the exit from the unconventional efforts that characterized monetary policy during the crisis.  And at first blush, Bernanke and his colleagues managed the process deftly in comparison to Bernanke’s ill-fated press conference in June as stock markets surged to new highs while Treasury yields edged down.  Attention will now shift to the timing of the first rate hike, still not expected to arrive until 2015.

It has been long known that the Federal Reserve desperately wanted to end the asset purchase program; the issue for months has been timing the first step in that direction in coordination with market acceptance that tapering is not tightening.  To that end, the Fed has leaned heavily on forward guidance to entrench expectations of the path of short term interest rates to cap the rise in long-term rates.  We knew that the time for such a move was soon at hand, with analysts largely split on the exact date between the next three meetings, with no forecast coming with much conviction (I thought they would wait until after the New Year).

To justify tapering, the Fed cited progress toward goals.  From the statement:

In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to modestly reduce the pace of its asset purchases.

The last labor report and its reported decline in the unemployment rate, were the final straw. Moreover, they have greater confidence in the sustainability in the pace of job gains.  First, fiscal policy is on a less contractionary path:

Fiscal policy is restraining economic growth, although the extent of restraint may be diminishing.

Second, FOMC members see the risks as largely balanced rather than tilted to the downside

The Committee expects that, with appropriate policy accommodation, economic growth will pick up from its recent pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate. The Committee sees the risks to the outlook for the economy and the labor market as having become more nearly balanced.

The Federal Reserve essentially disregarded the trajectory of inflation in this decision, falling back on stable inflation expectations and their forecasts to support the policy shift.

The Fed did not, as some expected, cut the thresholds, instead choosing to enhance the forward guidance to emphasize the expectation that rates would remain low:

The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.

Policy makers do not seem to be inclined to change the threshold.  If they can accomplish the same expectations for rates without changing the threshold, they retain flexibility and the ability to change the threshold at some point in the future if needed.

There was no hint of lowering interest on reserves.  Bernanke might not believe this would have much impact.  During the press conference, he said that credit was not tight.  Instead, willingness and ability to borrow were the cause of weak lending.  Basically, he might see this as a demand side problem, and lower interest on reserves is a supply side tool.

We learned that, assuming growth is more or less in line with the Fed’s forecasts, we can pencil in a $10 billion reduction at subsequent meetings until the program is wound down at the end of 2014.  To be sure, Bernanke emphasized the data dependent nature of the program, but it was clear that this is the expectation of the FOMC members.

We also learned that the Fed does not view quantitative easing as a natural extension of policy when rates hit zero, but instead it is a separate, supplemental policy.  Quantitative easing works via lowering the term premium, but in normal times this impact can be mimicked with forward guidance.  Moreover, quantitative easing comes along with some additional costs, including uncertainty of managing policy via the term premium and managing a greatly expanded balance sheet.  The Fed would like to wind down the asset purchase program before the costs outweigh the benefits, and note the benefits have fallen now that they have held rates down via forward guidance.

Bottom Line: Another historic moment for a Federal Reserve that has had its share of historic moments in the past several years.  Most likely, we can now move past the issue of tapering and asset purchases.  Barring a dramatic change in the data, I doubt the Fed will reverse course.  The issue now is to what extent incoming data impact our expectations of the first rate hike.

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