)
As expected, the FOMC (Federal Open Market Committee) tapered its asset purchase program by another $10 billion, evenly split between US treasuries and agency MBS.
This will reduce the purchases of treasuries in July to $20 billion (from $25 billion) and the purchases of agency MBS to $15 billion (from $20billion). This will bring the total monthly amount of asset purchases down to $35 billion, from $45 billion.
However, tapering is no longer a major market mover and unless there is a major change to the economic outlook, the pace of tapering is expected to remain $10 billion/meeting. Instead, attention has shifted to the hiking cycle.
Growing confidence
The FOMC was more confident about the post-winter reacceleration of the economy and said that growth in economic activity has rebounded in recent months, labour market indicators generally showed further improvement, and business fixed investment resumed its advance.
However, the GDP growth forecast for 2014 was revised downward, with a central tendency of 2.1-2.3%, down from 2.8-3.0% in March.
As we noted in our preview, this was unavoidable because the extreme winter had a devastating effect on GDP growth in Q1 (1.0% contraction quarter-on-quarter at an annualized rate).
The downward revision of unemployment and upward revision of inflation also led to a hawkish shift in policy rate projections for 2014-2016. After all, if labor market slack has decreased faster than expected and if inflation pressures are building, the Fed should start tightening monetary policy earlier than anticipated.
Outlook
At this pace of tapering, $10billion/meeting, we should see the end of QE3 by the meeting in October (final taper of $15billion) or December (final $5billion). The downward pressure on US treasury yields caused by falling supply and higher private demand is offsetting the upward impact of the Fed’s retreat from the market to a large extent, therefore a final taper of $15billion in October now seems more likely.
Given the uncertainty and disagreement about the exact size of the slack, it is difficult to give a precise description of the labor market conditions that would lead the FOMC to start hiking. After all, they have dropped the Evans Rule – which linked policy to numerical thresholds for the unemployment rate and inflation – and replaced it by a list of factors that will be taken into account: measures of labor market conditions, indicators of inflation pressures, inflation expectations, and readings on financial developments.
At present, Fed Chair Yellen thinks that there is still a lot of slack in the labor market. We do not think that wider measures of unemployment that take into account discouraged workers and involuntary part-time workers or the participation rate will improve within the next 12 months to such an extent that the dovish majority will be comfortable starting the hiking cycle, unless they change their way of thinking about slack or if – not completely unrelated – core inflation shoots up.
So with these qualifications in mind, we stick to our forecast of a Q42015 start of the hiking cycle for now. Since we do not expect the debate about slack to be resolved on its own merits, we see the core PCE deflator as the decisive factor. If core inflation shoots up, the FOMC is likely to hike earlier and we will adjust our forecasts accordingly.
More importantly, the debate is shifting from the timing of the first rate hike to the entire hiking cycle. The upward impact on longer-term US treasury yields of the hawkish shift in the dot plot for 2015-2016 is being offset by the dovish shift in the longer run rate projections. At time of writing, the dovish flavor of the twist in the dot plot is prevailing with yields lower post-meeting.
