Fed finds elixir for tapering QE without hurting

Tags: News
For six months, the US Federal Reserve has struggled to engineer a pullback of its bond-buying programme without unhinging financial markets. On Wednesday, the Fed did it.

The US central bank on Wednesday decided to trim its monthly bond purchases to $75 billion from $85 billion, taking the first step toward unwinding the unprecedented stimulus that chairman Ben S Bernanke had put in place to help the economy recover from the worst recession since the 1930s.

“Reflecting cumulative progress and an improved outlook for the job market, the committee decided to modestly reduce the monthly pace at which it is adding to the longer-term securities on its balance sheet,” Bernanke said at a press conference in Washington after a meeting of the Federal Open Market Committee.

Stocks rallied, sending benchmark indexes to all-time highs, and 10-year treasury yields rose just six basis points as the Fed coupled its decision to taper with a stronger commitment to maintaining an accommodative policy.

The S&P’s 500 index rose 1.7 per cent on Wednesday to 1,810.65, its biggest gain in two months. The market reaction was the opposite of Bernanke’s experience in June, when global equity markets lost $3 trillion in the five days after he said he might reduce his $85 billion bond purchases a month this year and end it by the middle of 2014.

Yields on the benchmark 10-year treasury note climbed 0.06 percentage point to 2.89 per cent, according to Bloomberg bond trader prices. That’s below the 2.99 per cent reached on September 5 on speculation that the Fed would taper that month.

In September, the Fed refrained from tapering in part because of the rise in borrowing costs.

Since then, policy makers have tried to convince investors that tapering quantitative easing isn’t tightening policy. They succeeded on Wednesday by coupling a $10 billion reduction in monthly asset buying with a stronger commitment to keep interest rates at record lows, according to Ward McCarthy, chief financial economist at Jefferies in New York.

“The Fed is trying to get policy back in the direction of normal without causing setbacks in the economy and too much distress in financial markets,” said McCarthy, a former Richmond Fed economist, who predicted the Fed would taper. “Based on the initial reaction, they found a magic elixir.” Bernanke said his actions were “intended to keep the level of accommodation the same overall and to push the economy forward.”

On Wednesday, the Fed reinforced its assurances that interest rate increases are far off by saying its benchmark rate is likely to stay low “well past the time that the unemployment rate declines below 6.5 per cent, especially if projected inflation continues to run below” its 2 per cent target.

Inflation measured by the personal consumption expenditures price index rose 0.7 per cent for the 12-month period ended in October, and the jobless rate last month was 7 per cent.

“It’s an important achievement” that markets are showing confidence in the Fed’s interest rate outlook, said Columbia University economist Michael Woodford. He urged central banks to adopt “forward guidance” as a form of stimulus at a Kansas City Fed symposium in 2012 before the Fed established the unemployment and inflation thresholds.

“They have been trying for some time to get across the point that expectations about the path of asset purchases and about the path of interest rates should be two separate things, but earlier in the year, there seemed to be some confusion in the markets about that,” Woodford said. On Wednesday, the Fed “underlined the difference quite firmly and the market reaction suggests that this is now considered credible.” Money market derivative traders pushed back their expectations for the timing of the first increase in the target for the benchmark federal funds rate, which has been between zero and 0.25 percent since December 2008.

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