The buzz surrounding the upcoming Federal Reserve meeting is centered on two questions: Will the Fed taper in September? And will financial markets respond as they did back in June in what we now call the “taper tantrum?”
To the first question, our answer is yes; but to the second, no.
So first, yes, we expect the Fed to begin reducing its pace of purchases of securities (both mortgages and Treasuries) and to announce this change at the conclusion of its September 17-18 two-day meeting.
Certainly, much can change between now and then. Should we see weaker-than-expected economic data, it might push back the starting date for the beginning of the end of the Fed’s program of purchases. Crucially, however, a likely September start to tapering is the consensus expectation–hence it is already priced in.
This is the crux of why we answer no to the second question. Conditions were different in late May when the Fed started to signal a shift in policy. The Fed’s statements, combined with its downgrading of the risks facing the economy and its above-consensus economic forecasts, all served to surprise the markets.
At that point, the Fed upgraded its outlook when the market expected it to downgrade. It wasn’t just the shift in policy; it was the shift relative to expectations that led to the violent and negative market reaction that followed: both bonds and stocks fell.
Looking forward, a repeat of the taper tantrum appears unlikely. And the fact that I’m commenting on it is exactly why. Because we’re having this discussion now removes the taper as a likely source for unexpected reasons for financial market uncertainty – at least to the degree we saw back in June.
There’s another important topic that needs to be addressed: What does tapering mean for interest rates? The Fed’s May comments and subsequent reaction not only changed expectations for when QE would end; they also changed expectations for how long the Fed would maintain its zero-interest-rate policy. That speculation exacerbated the breadth of global financial market uncertainty because the exit from zero interest rates holds much greater significance for broader financial markets than does the purchases of Treasury and mortgage bonds.
But Bernanke has taken pains to disabuse the market of the interpretation that rates are set to jump any time soon. Furthermore, by this point, he has likely convinced everyone both that the Fed will continue to maintain a zero-interest-rate policy and that this decision is separate from the decision to taper. Presently, the market now expects the first Fed tightening will occur in March of 2015.
The broader issue affecting the outlook for interest rates remains the performance of the economy, and even more importantly, the Fed’s assessment of that performance. Market expectations stand high for a second-half economic rebound, and the Fed appears to share that view. Meeting or exceeding these expectations likely keeps rates on an upward trajectory. Disappointment, however, means that rates would fall first.
Recent increases in interest rates (taking the 10-year to just over 2.70%) are a reflection of more upbeat economic data that came after the disappointing July payroll report released on August 2. And that better data heightens expectations for continued positive economic momentum in the second half of the year. Our view is more cautious—we think heightened expectations for growth could make interest rates vulnerable to the potential for declines in the shorter term if those expectations turn out to be overly optimistic.