Policy

Fed Follies

September 24th, 2013 | By Nick Sargen

Highlights
  • Equities and other risk assets rallied following the Federal Reserve's surprising decision to delay the start of its tapering program. Amid the euphoria, investors are now left wondering what the Fed's game plan is.
  • Chairman Bernanke cited two reasons: (i) financial market conditions are less supportive of the housing market; and (ii) a fiscal showdown in Washington poses a threat. My own take, however, is these reasons are not compelling for it to have rejected a modest reduction in bond purchases.
  • The decision achieved one important objective – namely, it helped convince market participants that the Fed is in no hurry to tighten monetary policy. While some observers believe the Fed's credibility has been hurt, the test of its willingness to risk higher inflation will occur when the economy gains traction.
  • In the wake of the Fed's decision we are increasing exposure to investment-grade corporate bonds in fixed-income portfolios, but we are not altering equity portfolios or our stock-bond allocations.

Factors Influencing the Fed's Decision

The announcement that the Federal Reserve would continue purchasing $85 billion of bonds on a monthly basis surprised the markets, considering that three months earlier Chairman Bernanke indicated the Fed was contemplating scaling back the program later this year and eliminating it by mid 2014 if the unemployment rate fell below 7.0%. The consensus view was the FOMC would likely begin the tapering process in September assuming the economy and job picture did not deteriorate, although some commentators thought the Fed would hold off for a while.

The FOMC statement that was released stated that the Committee still expects economic growth will pick up from its recent pace and the unemployment rate will gradually decline. However, the economic projections that accompanied the release showed the Fed is now projecting 2014 real GDP growth to average about 3.0%, or about a quarter of a percentage point below the previous forecast. This appears to reflect greater uncertainty about the resilience of the housing sector in light of a one percentage point increase in mortgage rates in the past few months. At the same time, Chairman Bernanke noted that fiscal policy is restraining growth and there is increased uncertainty about the outcome of federal budget deliberations.

In a press conference, Chairman Bernanke downplayed the increased importance of the unemployment rate in the decision making process. Previously, the Fed had indicated that it would like to complete the tapering process when the unemployment rate reached 7%, but that it would not contemplate tightening policy until unemployment fell to 6.5%. In this regard, the Fed now appears less inclined to follow a rules-based policy, and will use its discretion to gain policy flexibility.


Uncertainty about Tapering Alters Expectations about Fed Tightening

While the bond market rallied on the news and U.S. equities established new record highs, market participants at the same time have questioned the Fed's motives: Is the Fed merely waiting for more data to be sure of its decision? Or, is it trying to send a clearer signal to market participants that tapering is not equivalent to tightening monetary policy?

My own interpretation is that it is difficult to know, as the vote apparently was very close. I believe Fed officials were concerned by the increases in bond yields and mortgage rates that occurred in recent months, which could derail the housing recovery at some point if sustained. By delaying the tapering process, they are seeking to convince market participants that any tightening of monetary policy is unlikely until at least 2015 – a message that is now being priced into the bond market. (Previously, the market was pricing in tightening in the second half of 2014.) The irony, thus, is that the Fed had to increase uncertainty about the timing of its tapering decision to convince market participants that it was in no hurry to raise interest rates.

While Fed officials may be pleased with the latest response, some commentators have questioned whether the Fed's credibility could be damaged. My own take is that the Fed's initial attempt at "forward guidance" may have fallen short of the mark, but the need to resend a signal to the market does not mean it has lost credibility. The principal reason is that inflation is still tame. The test of the Fed's credibility as an inflation fighter is yet to come when the economy is gaining momentum and inflation expectations are rising. Should the Fed hold off from tapering then, investors would conclude it is prepared to risk higher inflation in order to lower unemployment.


Positioning Portfolios

Prior to the FOMC meeting, we altered our investment strategy for balanced portfolios by reducing our overweight position in equities from 10% to 5% primarily because we considered the stock market to be fairly valued, and we anticipated the Fed would begin to scale back on QE this year. Following the Fed meeting we are maintaining our stock-bond allocations on grounds that it is only a matter of time before the Fed begins to taper. Also, we continue to believe bond yields will rise further as the economy gains traction into 2014.

One change we are making is in fixed income portfolios, where we are increasing our allocation to investment grade corporate bonds to establish a moderate overweight position. Our logic is that the Fed's latest decision is likely to make spread products more attractive to investors.