Fed's Stimulus Inconsistencies

Briton Ryle

Updated July 12, 2013

Is this a scene from the Twilight Zone or something? Every day it seems we are waking up to a new Federal Reserve unconnected to any of the previous ones. And their words keep changing.

Since the last FOMC meeting just three weeks ago, market sentiment has turned at least four times.

bernankeFirst, the markets turned bearish when Federal Reserve Chairman Bernanke introduced the idea of possible monthly bond purchasing reductions later this year. They then turned bullish days later when several Federal Reserve members came out to say that stimulus is still on.

Then the bond market turned bearish again last Friday when solid jobs numbers strengthened the case for stimulus tapering. And finally bonds turned bullish yet again this week when the released FOMC June minutes, plus further testimony from Chairman Bernanke, stressed stimulus is not going away.

All over the airwaves and in print, commentators and analysts are scratching their heads trying to figure out what the heck is going on. Just what is the FOMC up to?

Reading Past the Headlines

The first thing we need to do is relax; stimulus is not going away completely just yet.

The turbulence in the markets is just an overreaction to sound-bites and short little phrases. We trade in a headline-driven market in an age of tweets and snippets intended to grab people’s attention. And nothing grabs an investor’s attention more than, “It’s the end of stimulus!”

The Fed’s message has been the same all throughout. The markets are just so eager to get a trading edge that they will jump on any news before the full story has been analyzed.

Let’s look at just 4 key points that have been confusing the markets lately.

1.) Two Separate Policies

Let’s start with the biggest troublemaker of them all: the markets’ assumption that Fed stimulus measures are an “all-or-nothing” deal. They are not. The FOMC minutes released this week made it perfectly clear, just as Bernanke and other Fed members have before: the monthly bond purchasing program is separate and distinct from the low interest rate policy.

Traders and commentators have it in their heads that any commencement of bond purchasing reduction means a rapidly approaching end of all Fed stimulus. It does not. Bernanke has explained it, the FOMC releases have printed it, and Federal Reserve members have reiterated it: each of the two measures has its own timetable.

While bond purchasing may be wound down sooner, interest rates will remain “highly accommodative” for a “considerable period of time”.

2.) Interest Rates

The key stimulus policy has always been the interest rate between the Fed and the banks, now some 4 years at near zero percent. The requirements for raising this rate have been constant for years: the interest rate will remain unchanged as long as the unemployment rate remains at or above 6.5% and near-term inflation remains at or below 2%.

But there is a window to both requisites for changing the rates. Unemployment must be at least 6.5%, with the Fed repeatedly stating that interest rates could remain unchanged even if unemployment falls below 6.5% to ensure the job recovery is solid.

The window for the inflation rate is 0.5% above the 2% target, with the Fed repeatedly stating that inflation expectations can rise to 2.5% with still no change to the overnight lending rate.

So where are we today? Unemployment is at 7.6%, and inflation is at 1.1%. If any traders cite last Friday’s strong jobs report – which included upward revisions to April’s and May’s jobs numbers as well – as an indication that stimulus is on its way out, just show them the countless quotes and communiqués over the past several years indicating the Fed’s jobs and inflation targets.

3.) Monthly Bond Purchases

It must be remembered that the Fed’s monthly bond purchases were not part of the original stimulus packages. They were introduced as QE3 in September 2012 starting at $40 billion per month and were subsequently increased to $85 billion per month three months later. They are an add-on stimulus measure designed to apply further pressure on interest rates in the marketplace.

Why? Because the all-time low in the 10-Year Treasury’s yield was hit in July of 2012. Yields then shot up dramatically, gaining nearly 50 basis points in just 3 weeks by the middle of August.

But the Fed wanted to keep rates down, since the economy was not strong enough to handle the increased cost of money. Since the Fed could not push its own bank lending rate down any further (already near zero), the only thing it could do was to throw cash into the system. So a month later, on September 13th, 2012, out came the monthly bond purchasing program.

But unlike the near-zero interest rate, which has two key requisites (6.5% unemployment and 2% inflation), the monthly bond purchasing program (aka QE3) has no target requisites at all. When Bernanke said in June that the unemployment rate may likely be near 7% by mid-2014 when bond purchasing might be completed, he did not say the rate has to be 7% for QE3’s termination, but simply that it is expected to be near that level.

As long as the economy continues to show signs of improvement, tapering could still commence this fall. But if the recovery is weak, bond purchases could even increase, as the Fed has repeatedly stated.

4.) The Key Gripe: “Push Back”

The phrase in Bernanke’s testimony on Wednesday that seems to have caught people off-guard was: “If financial conditions were to tighten to the extent that they jeopardized the achievement of our inflation and employment objectives, then we would have to push back against that.”

With that, commentators effectively threw up their hands and said, “Make up your mind.”

But in implying that the FOMC would continue its bond purchasing to “push-back” against rising long-term bond yields and mortgage rates, Bernanke said nothing new at all. Pushing down rates was what the QE3 bond purchasing program has been all about.

Even the FOMC press release states immediately following the itemization of the monthly bond purchases, “These actions should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.”

There is no reason why the Fed’s use of monthly bond purchasing to push down yields and mortgage rates should surprise anyone, for that has been its designed purpose from the start.

Saying in June that bond purchases “might” be reduced, and then saying this week that bond purchases “might” be needed to push back rates, is in line with what the Fed has been saying for months: “The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.”

What to Make of It

June’s hint of reducing bond purchases did not say the Fed would terminate the program this year. This week’s Fed talk of continuing the bond purchases into 2014 is not a reversal but a confirmation.

An article indicating that “about half of Federal Reserve policymakers favored ending its massive economic stimulus late this year” under the headline “Some Support for Stimulus End in 2013” is just one example among many of how headlines and short bites can confuse things.

While some FOMC members do want to see bond purchases tapered this year, they are not calling for the complete termination of the monthly purchases nor the raising of interest rates in 2013.

But even if some members were to opine that stimulus should end in its entirety this year (which is not the case), we must remember that the FOMC makes decisions based on majority votes. Investors must never trade based on any individual’s preferences, even if they are members of the Federal Reserve. We must base our trading decisions on official Fed policies.

And they are simple:

  • Stimulus’ key policy of ultra low interest rates will remain unchanged until unemployment reaches at least 6.5% and short-term inflation reaches not more than half a percent above the 2% target.
  • Stimulus’ add-on policy of monthly bond purchases “might” see tapering later this year, the timing and size of which are data dependant, “might” terminate by 2014, still depending on data, and “might” increase at any time, similarly depending on the data. All these “mights” are simply a “heads-up”. All testimonies from June to this week have born those consistencies.

Does any of this surprise us? It shouldn’t. The lips speaking have never changed their message. The ears listening have changed their interpretations.

Joseph Cafariello


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