The Fed’s full of surprises.
Following its two-day FOMC meeting, the Federal Reserve announced on Wednesday it will continue to purchase $85 billion in bonds each month. The decision comes on the heels of hints by Fed Chairman Ben Bernanke that the central bank might be ready to start tapering its asset purchases in September. The Fed also revised its economic growth forecasts lower. Its federal funds target rate will remain at 0%-0.25%.
Given that unemployment is improving—despite some significant flaws in the job recovery—and economic data indicate moderate economic growth, we had anticipated that the Fed would begin a “tiny taper” in September. However, FOMC members expressed concerns over the pace of progress and would like to delay tapering “to get affirming evidence that the economy is conforming” to the roadmap the Fed laid out in June. We believe that significantly higher borrowing costs—mortgage applications have dropped 71% since May—and signs of consumer weakness had a meaningful impact on the FOMC’s decision.
The Fed’s decision not to taper comes as a huge surprise to the market, given that most economists and investors were anticipating at least a slight pullback in its bond purchases. However, this isn’t the first time the Fed threw us a curveball; Bernanke shocked the markets in May when he initiated “taper talk.” Five key takeaways from the Fed’s decision are:
The Fed’s concerned about the debt-ceiling debate and a budget battle in Washington.
In Bernanke’s press conference, he explained that upcoming “fiscal headwinds” could negatively impact the economy.
The taper timeline might be changing.
The Fed revised downward its 2013 economic growth forecast to 2%-2.3% from 2.3%-2.6%. For 2014, the Fed expects 2.9%-3.1% GDP growth as compared to previous estimates of 3%-3.5%. Further, Bernanke stressed that tapering is not on a “preset course.” And while tapering could still happen later this year, any subsequent tapering would be predicated on continued improvement in the economy.
The Fed did not expect—or want—rates to move as high as they did based on taper talk.
The Fed believes that lower rates have had a positive impact on the economy and that higher rates could meaningfully impact growth. In addition, note that the 2016 fed funds target rate forecast, which determines short-term rates, is 2%, well below the long-term median of 4%, and that short rates aren’t expected to return to 4% for many years. Therefore, policy should remain extremely accommodative.
Expect the unexpected from the Fed.
This isn’t the first time we’ve been surprised by the Fed’s remarks. It’s hard to tell what the Fed is thinking from the FOMC minutes, particularly because they don’t reflect the latest economic data.
The unemployment goalposts might move.
The Fed recognizes that the drop in the unemployment rate is being driven by declining participation, leaving open the option to push its unemployment target lower.
The delay of Fed tapering speaks volumes about the unique environment we’re in. Financial repression, a series of government policies designed to keep real rates below GDP growth, is here to stay—perhaps even longer than we expected. Investors need to recognize that financial repression redefines risk and return expectations for different asset classes. Investments that have historically been considered low-risk—Treasuries for example—actually have become a higher risk amid financial repression. The Fed’s announcement serves as a reminder to investors to examine their asset allocations and ensure appropriate exposure to risk assets.
Looking back, QE was always designed to influence the bond market rather than other asset markets. Going forward, the unwinding of the Fed’s bond-buying program should have an outsized impact on bond markets, with spillovers into other higher-yielding asset classes such as emerging markets and corporate debt. But the brunt of the impact will be borne by fixed-income securities. In effect, we must all learn to deal with a world where the risk-free rate is no longer risk-free.