Wednesday, June 19, 2013

The Fed's Latest Announcement Regarding the Direction of Monetary Policy

As expected, the Fed announced this afternoon that it will continue QE3 without tapering, for now.  In addition, it released its latest forecasts for the economy.  What are the headlines?  During the press conference following the announcement, Ben Bernanke said that, if the Fed forecast turns out to be correct, the Fed will probably begin tapering its purchases of bonds later this year and end QE3 by mid-2014.  Also, a large majority of FOMC participants anticipate the federal funds rate beginning to increase in 2015.  The initial response of the market has been a sharp decline in stocks and a significant increase in interest rates with the ten-year bond rising to 2.33%, the highest since March 2012.

Let's take a closer look at the Fed's view of the economy.  First, it should be noted that the projections are those of each of the 12 district banks, not the Federal Reserve itself (i.e., not the Board of Governors or Ben Bernanke).  The table below show the central tendency of the forecasts, which is the range of forecasts after eliminating the 3 highest and 3 lowest forecasts for each variable. 
Economic growth
2.3 to 2.6%
3 to 3.5%
2.9 to 3.6%
Unemployment rate
7.2 to 7.3%
6.5 to 6.8%
5.8 to 6.2%
0.8 to 1.2%
1.4 to 2%
1.6 to 2%
note: the forecast for the unemployment rate is for the end of the year

In addition to the forecasts, the Fed noted that it thinks the downside risks to the economy have subsided (less risk of a slowdown).  The forecast for economic growth for all 3 years is somewhat more optimistic than that of most private forecasts, but the other forecasts are in line with other forecasts.  What are the implications for monetary policy?  The Fed has announced thresholds (their word, not mine) for inflation (forecast above 2.5%, 1-2 years in the future; it relies on a forecast of inflation since it takes time for monetary policy to impact inflation) and the unemployment rate (6.5%) for when they are likely to consider increasing the federal funds rate.  Today, Ben Bernanke suggested that QE3 would likely end as the unemployment rate reached 7%.  Given that the Fed expects the unemployment rate to reach 7% in Spring/Summer 2014, QE3 will likely end around that time (if their forecast is correct).  Since it will preceded by a gradual reduction in bond purchases, the tapering will likely begin in late 2013.  Ben Bernanke emphasized that if the data shows a slower economy (including a higher than expected unemployment rate), QE3 could be extended further into 2014 (and thus tapering may not start until sometime in 2014).

What are the key takeaways from the latest news from the Fed?  It is more confident about the strength of the economy, but still thinks it requires stimulus.  In addition, it provided some clarification as to when it would begin to taper and eventually end QE3, though the exact timing is dependent on the data.  As of now, it expects that tapering will begin later this year with QE3 coming to an end by this time next year.