Three hours. That's when the FOMC statement and the updated economic and financial forecasts will come out, with Bernanke's press conference and Q&A following half an hour later. Most importantly, we'll learn about how the Federal Reserve will proceed with the slowing of its bond purchases - colloquially known as "Taper". How the Fed decides to move forward can have massive implications for the global economy. Such an important shift in monetary policy naturally carries with it the opinions of many journalists, among which The Economist has some interesting thoughts on how to deal with the coming unwinding of their most recent QE program.
The economy has improved enough to justify a small reduction in the pace of bond-buying--to, say, $75 billion a month. But it is not strong enough to withstand a sudden stop of such purchases, let alone a quicker return to raising short-term interest rates. The trouble is, that is exactly what the taper talk has led investors to expect. It is why long-term bond-yields have soared since May. And it is an impression the Fed must dispel on September 18th.
I have to wonder who, exactly, connects "taper" with "a sudden stop of such purchases", given that The Economist suggests that investors at large have, in fact, made such a connection. Nevertheless, The Economist does make some compelling points about how to proceed.
Investors interpreted the promise of tapering as evidence of a big shift in the Fed's priorities. That is partly because the taper talk was accompanied by a very public debate within the central bank about the downsides of bond-buying, particularly the risk of inflating bubbles in financial markets. And it is partly because the Fed provided an ambitious end point (ie, stopping bond purchases when the jobless rate reaches 7%) with little clarity about how it planned to get there, or how that goal weighed against other signs of weakness such as the uncomfortably low inflation rate.
This is a far more compelling point. The issue The Economist appears to have identified is the lack of clarity coming from the Fed. This naturally raises the question of how should the Fed better spell out its path forward.
First, it must leave no doubt that the priority is to support growth; that the pace of bond purchases is being reduced because the economy is ready for it; that the tapering will be cautious; and that if the recovery wanes the bond-buying will be stepped up again. Second, the Fed's promises about its future plans should eschew mechanistic reliance on one economic indicator. If America's jobless rate is falling but other measures of the economy's health are weak, the central bank should explain it will err on the side of keeping policy loose for longer.
Whether or not you agree with the Fed's actions, this seems to be fairly common sense advice. That being said, what was left out of The Economist's analysis is what the potential effects may be with a slowing of bond purchases on markets. Regarding the bond and equity markets, ZeroHedge has made an interesting observation:
According to the Fed, QE's aim was to drive down interest rates to unattractive levels by purchasing bonds in the market, thus encouraging participants to purchase riskier (and higher-yielding) securities. As Cornerstone's Ronnie Spence notes, this risk-seeking behavior in theory boosts asset prices (and increases the 'wealth effect'). However, when one examines what has actually happened under QE, only stock prices have followed the QE theory.
Their point is supported by supplying two graphs, one of the S&P and the other of 10 year US Treasury yields. The graph of the S&P shows exactly what you would expect, QE drives up equity prices:
However, what's interesting is the graph of the 10 year US Treasury yields:
Spence points out, that the drop in rates in response to QE likely results from the plunge in equity prices that has resulted when the Fed has looked to end their QE programs. Put another way, "Taper" is a false narrative for higher rates when in fact all the 'taper' risk is in stocks (and historically traders haven't priced it in until the money actually stops flowing).
What do you monkeys think? How do you see the FOMC meeting unfolding? What markets will bear the brunt?