Kristina Hooper, US investment strategist and head of US Capital Markets Research & Strategy for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
The minutes from the FOMC’s Oct. 29-30 meeting were released last week, offering additional insight into the Fed’s thoughts on the economy and tapering. Here are our key takeaways:
The Fed maintains a modestly positive—but cautious—outlook on the US economy.
The FOMC believes growth in the second half of 2013 might be somewhat weaker than previously anticipated, but that the economy will continue to grow. Also, FOMC members agreed that the employment situation continues to improve—albeit very slowly—with significant slack remaining in the labor market.
Washington politics are a huge headwind.
The Fed’s still concerned about the impact of government spending cuts, budget battles and the possibility of another government shutdown or debt-ceiling crisis. FOMC members believe “the stance of fiscal policy remains one of the biggest headwinds over the medium term.” In addition, they expressed concern about the negative impact of “repeated fiscal impasses” on consumer and business confidence.
The Fed believes the consumer is critical to the recovery.
A number of FOMC members noted that their outlooks for economic improvement were “contingent on a pickup in growth of consumer spending.” They discussed a laundry list of factors that might contribute to increased consumer spending: low interest rates, a reduction in debt, continued improvement in employment, lower gas prices, higher real incomes, and the “wealth effect” of rising home prices and equity values. The FOMC recognized that consumer sentiment has been “unusually low, posing a downside risk to the forecast, and uncertainty surrounding prospective fiscal deliberations could weigh further on consumer confidence.”
FOMC members debated what would trigger the taper and how it would be communicated.
There was a discussion about the merits of relying on a single metric to determine when to begin winding down its bond-buying program. Some FOMC members have reservations about adjusting the pace of QE based on a single metric such as the unemployment rate. Others argued that there may come a time when the Fed has to taper even if economic conditions don’t significantly improve. But if that happens, then the Fed would use some other form of accommodation. Still others argued that the Fed’s QE should no longer be data-dependent. Rather, they believe the Fed should have a specific wind-down plan, announcing either a specific timeline for tapering or the total size of remaining asset purchases. Even the type of tapering stirred debate. Some participants voiced a desire for balanced tapering between Treasuries and mortgage-backed securities—more so than previously—while others preferred trimming Treasuries more rapidly.
The Fed’s strategy may be shifting from buying bonds to issuing forward guidance.
The FOMC minutes seem to suggest that the Fed is laying the groundwork to rely less on asset purchases as a tool while its target interest rate is close to zero, and relying more on forward guidance. Only two members supported lowering the unemployment threshold, which might be the additional accommodation the Fed uses if tapering occurs while economic conditions are still weak. Markets are already pricing in the delay in the first rate increase to closer to the end of 2015, if the unemployment threshold is lowered. So there’s already an expectation by markets that tapering will require further accommodation through other policy tools.
With tapering, it’s more about the method and less about the timing.
Much of the market’s focus on the minutes seemed to center around the statement that the FOMC expects tapering to begin “in the coming months.” However, it seems that more attention should have been given to the debate over whether the FOMC should be data-dependent when it comes to adjusting asset purchases or whether it should articulate either a timeline or a finite amount of purchases for winding down QE3.
It’s an important question because the two approaches create very different market behaviors. When a wind-down is spelled out, it becomes priced in and the market acts accordingly. However, when a wind-down is data-dependent, it keeps the market guessing and, typically, creates more volatility as expectations constantly adjust. A data-dependent wind-down is also likely to have a greater impact on the economy because it remains in place on an “as-needed” basis, which is more likely to support the stock market.
Ultimately, the FOMC minutes don’t change our outlook much, especially given that the Fed met prior to Janet Yellen’s testimony before the Senate Banking Committee. We still expect that the earliest the Fed will taper is March 2014. Still, investors must recognize that tapering is inevitable. And despite this reality, we’ll be in an environment of deleveraging and financial repression for years to come. So while equity valuations are looking a little stretched after a strong run for stocks, investors still need adequate exposure to risk assets. They just need to be selective in choosing them.
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