Auto-pilot QE and the Federal Reserve’s taper dilemma

November 26, 2013

 It wasn’t supposed to be this way.

When the U.S. Federal Reserve launched its third round of quantitative easing, or QE3, it was hailed as an “open-ended” policy that would last as long as needed. Most important for investors, the pace of the bond buying – which started at a somewhat arbitrary $85 billion per month – would be “data dependent.” Especially throughout the spring, officials stressed they were serious about adjusting the dial on QE3 depending on changes in the labor market and broader economy. But as the unemployment rate dropped to 7.3 percent last month from 8.1 percent when the program was launched in September, 2012, the bond-buying has effectively been on auto-pilot for 14 straight months.

Now, some are wondering whether the decision not to at least tinker with the program has made the first so-called taper a bigger deal than it needed to be. “When you don’t react to small changes in the data with small changes in the policy then the markets tend to read more into it when you do change policy,” St. Louis Fed President James Bullard said last week after a speech in Arkansas. “It makes policy a little more rigid than it maybe should be.”

Bullard, who in June cited falling inflation when he dissented against a Fed policy decision to stand pat, continued:

“I’ve actually talked with my staff about this because we haven’t actually changed the policy. If it had been me I would have been more willing to change it meeting-to-meeting and be more responsive to incoming data. But there is a certain reluctance on the part of the committee to go there.”

U.S. economic data to be sure has been mixed this year: job growth has bounced around, inflation drifted lower, housing mostly continued to rebound, and fiscal policies grew tighter with higher taxes and lower government spending. But through all the fluctuation the $85-billion in purchases has held firm; it has almost become a new normal for investors so that any talk of adjusting it is met with sharp market sell-offs. Chairman Ben Bernanke learned that the hard way in May and June when he talked about the Fed’s general plan to trim QE3 later in the year as long as the economy continued to improve. In response, borrowing costs rose around the world and in the United States, causing tighter financial conditions that played a big roll in the Fed leaving the QE3 dial alone throughout the summer and autumn.

Now, with the economy gaining some steam, anxiety is again running high that the central bank is preparing to reduce the easing program, be it in December, January or in March, which remains the consensus among Wall Street economists. But whenever that time comes, and the Fed finally lives up to its mantra of “data dependent” QE3, chances are markets will respond abruptly and unpredictably. “All they did was open their mouth in May and June and we had a significant freak-out in the market that wiped out all the benefits of QE3,” said Brian Reynolds, chief market strategist at Rosenblatt Securities. “The first move is a big deal.”

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