July FOMC Preview: Fed Won’t Taper QE At This Meeting

The Federal Reserve is unlikely to trim the pace of its asset purchases at this week’s meeting, but policymakers will use the July meeting as a chance to debate how to best prepare financial markets for a looming reduction of the bond-buying program. The tapering of quantitative easing program will most likely happen in September or December – when Fed Chairman Ben Bernanke gets to explain the policy change at his post-meeting press conference.

The Federal Open Market Committee’s meeting starts Tuesday. A statement will be released at its conclusion around 2 p.m. EDT Wednesday. There are no forecast updates or a press conference at this meeting, so markets are likely to hang on every shift in wording in the statement.

Paul Ashworth at Capital Economics noted that since the overhaul to the Fed's communications framework in early 2011, major policy changes are increasingly made in the four meetings each year, which includes this September, when FOMC participants update their economic projections and Bernanke holds a post-meeting press conference. Nothing much tends to happen in the other four meetings each year, with any changes restricted to tweaking the language in the accompanying statement.

“We are not suggesting that the non-press conference meetings are now a complete waste of time,” Ashworth added. “The Fed would make changes at these meetings if they were urgently required.”

As an example, in response to signs of a worrying slump in activity and employment growth, the FOMC did launch its maturity extension program known as "Operation Twist" at a non-press conference meeting in September 2011. But that change had been heavily advertised ahead of time in Bernanke's Jackson Hole, Wyo., speech just a few weeks earlier.

“Nevertheless, it does appear that if major shifts in policy can wait, the Fed would prefer to make them when it can use forecast revisions to justify those changes and Bernanke's press conference to explain them,” Ashworth said.

In his press conference after the June policy meeting, and in recent congressional testimony, Bernanke indicated that the FOMC is preparing to “moderate” the monthly pace of QE purchases later this year, assuming economic data continues to improve.

At this week's meeting, Fed officials might make that indication official by putting a sentence or two to that effect into the policy statement, HSBC's Chief U.S. Economist Kevin Logan said. Bernanke hinted at that possibility in his press conference, when he said, “Future policy statements may include elements of this (QE clarification).”

There has also been some speculation that the Fed could change its forward guidance at this meeting.

“We have little doubt that will be an active topic of discussion, particularly since Bernanke has suggested the 6.5 percent unemployment rate threshold might not be indicative of the state of the broader labor market,” Michael Hanson, U.S. economist at Bank of America Merrill Lynch, said in a note to clients. “But we think it is too early for a revision to these thresholds.”

A recent Bloomberg poll reported that half of 54 economists surveyed expect the Fed to start tapering in September. Bank of America Merrill Lynch’s rates strategy team said the markets are pricing in a 75 percent chance of September tapering, while the bank continues to hear from investors who think September is a “done deal.”

“The probabilities of the Fed slowing the pace of QE3 purchases sometime between September and the end of the year look to us to be roughly evenly distributed,” Hanson said. But with growth and inflation running notably below the Fed’s projections for this year, Hanson believes the Fed won't start tapering until December.

The problem for the FOMC is that in September they will have to review their forecasts, which are too optimistic on both growth and inflation, Hanson noted. It will be very difficult for the FOMC to simultaneously mark-to-market lower their forecasts yet announce the start of tapering.

Data Dependent or a Done Deal?

A key question for the meeting this week is how the FOMC will recognize the weaker incoming data. Second-quarter gross domestic product will be released on Wednesday morning before the FOMC statement comes out, and expectations are for a weak reading of 1.0 percent annualized rate.

“We do not think a weak second-quarter GDP report alone would alter the Fed’s plan to reduce its bond buying later this year,” Thomas Costerg, an economist at Standard Chartered PLC in New York, said in a note to clients.

Overall, the private sector has remained resilient. Costerg said that nonfarm payroll gains averaged 196,000 per month in the second quarter, broadly in line with the historical one-year average. The housing market was also a key driver of underlying growth; new home sales in June rose to their highest level since May 2008. The wealth effect from stock-market gains and rising home prices has also cushioned the fiscal consolidation somewhat. Interest rates remain low with the Fed’s accommodative policy, although long-term rates have risen over the past few weeks.

The Fed’s investment purchases have swollen its portfolio to $3.53 trillion -- a fourfold increase since before the 2008 financial crisis. Eventually, the Fed will need to gradually sell its portfolio. The main reasons why the FOMC wants to taper off the QE program have to do with the perceived costs of the program.

HSBC's Logan pointed out that unlike the Fed funds rate, QE as a policy tool isn't costless. QE adds securities to the Fed’s balance sheet, securities that the Fed will have to hold for some time to convince financial markets that monetary “accommodation” will be around for a while. Buying securities this month and selling them next month would have no meaningful easing effect on financial conditions. Buying hundreds of billions of dollars worth of mortgage-backed securities and longer-term Treasuries, and holding them off the market for several years should, however, put some downward pressure on long-term interest rates. But holding these securities on the balance sheet creates potential costs for the Fed, costs that the FOMC would like to limit.

Since Bernanke first dropped hints in mid-May that QE tapering might occur later this year, the yield on the 10-year Treasury note has jumped from roughly 1.9 percent to 2.6 percent.

“The debate within the Federal Open Market Committee over whether or not to start tapering the QE program is probably over," Logan said. "The question now is how to sufficiently prepare markets for the event and to decide when to actually start tapering.”