FOMC Statement Wording. Janet Yellen kept markets sweet by maintaining the wording used in her previous statement, “significant under-utilization” to describe the labour market and “considerable time” for the length of the period after the asset purchase program ends before the first rate hike.
When will the program end? As expected the Fed cut the current rate of monthly bond purchases, conducted under their third round of quantitative easing (QE3), by $10 billion to $15 billion. While the Committee will end this program next month, it does not mean an end to their bond purchases.
How long is “considerable”? In her first ever post FOMC press conference last year, Janet Yellen made an off-script remark “something in the order of six months”. She later backed away from this, even though the market hasn’t forgotten, since emphasising that there is no “mechanical interpretation” of what the term means. The truth is that it is however long they want it to be.
“Contingent on the Economic Outlook”. As for the Fed’s own economic outlook, three months is a long time in forecasting – “There has been a little bit of downgrading”. The Fed’s central tendency of the projections for real GDP growth in 2014 is now 2.0 to 2.2 percent, down from 2.1 to 2.3 percent. However, this compares to their forecast of 2.8 to 3.0 percent in March!
Follow the dots. There has been much focus on the Fed’s so-called dot plot, the graphic that plots each FOMC participant’s appropriate level of the target federal funds rate at the end of the specified calendar year or over the longer run. The expected rate path now appears to be steeper. However, these individual projections carry their own uncertainty and even then the dispersion of the ‘dots’ alone does not give us any statistical confidence in the path of interest rates derived from the mean of these dots. Janet pleaded the fifth on her dot – “I don’t want to identify myself”.
Fed Balance Sheet Reduction: While QE3 will end next month, the Fed will still be buying bonds through the reinvesting of proceeds from maturing Treasury securities and principal payments from holdings of agency debt and MBS. Their balance sheet now stands at circa $4.5 trillion, up from the pre-crisis level of circa $860 billion. The Fed ‘will only taper and eventually cease the reinvestment policy once they are sure normalisation is successfully underway’. On returning the balance sheet to pre-crisis levels, “it could take to the end of the decade to achieve those levels”.
Impact on the US Treasury: If the Fed ends their reinvestment policy it will, in effect, end a funding source for the US government. When the Fed’s treasury security holdings mature, the issuer (the US government) would then be required to repay the principal. A balance sheet reduction of $3.7 trillion by the end of the decade is therefore inconceivable without debt monetisation. This would of course erode the credibility of the central bank, the US dollar and the confidence in the system. In truth, they are already getting this benefit because interest income is remitted to the Treasury.
Uncertainty: “Things will depend on how the economy evolves. That will change over time and there’s a good deal of uncertainty associated with it.” The Fed has already conceded that the recovery has been slower than they expected given their unprecedented level of monetary stimulus. Therefore markets might be overplaying the Fed’s confidence in being able to normalise monetary policy without significant market dislocation.