After four years of zero interest rates, the Fed has struggled to communicate monetary policy as it has implemented new and untested tools unfamiliar to investors. Furthermore, if a monetary policy tool stops working effectively or is increasingly viewed as detrimental to market functioning and financial stability, simply stopping its use may not be the best way to exit a program that has generated significant dependencies. We think it's becoming apparent that quantitative easing is losing appeal within the Fed, especially with the growing knowledge that exiting from the program without disrupting markets could take decades and gets longer with each addition to its balance sheet.
Ahead of Chairman-elect Janet Yellen's Senate confirmation hearing Thursday, the Fed released two papers last week that describe a way out of the 'QE trap' - that is: while QE has become increasingly counterproductive, the Fed still sees a need for extraordinary monetary accommodation. To solve the dilemma, the Fed wants to gradually taper its asset purchases (and perhaps shift them more to agency and mortgage-backed securities) while signaling that it will keep short-term rates lower for longer than investors anticipate. Currently, the market expects the Fed will start hiking rates in 2015 based on projections for the unemployment rate falling below 6.5%. The Fed believes that by lowering the unemployment threshold to 6% or below they can both offset the negative consequences of tapering and ease overall monetary policy further. In practice, adopting more aggressive 'forward guidance' could delay rate hikes until 2016 or 2017 (depending on how the market and employers respond), likely keeping ten-year Treasury yields below 4% without additional quantitative easing.
David Fuller's view Well, it is a nice theory from the Fed. The reality is that herding investors is challenging - sort of like herding cats rather than sheep - especially if the monetary food supply is being tapered.
I think Ben Bernanke is leaving the Fed at just the right time. There is no way out of QE for the Fed that does not spark investor fears and create a period of market turbulence. How much turbulence depends, in part, on how much further they inflate the stock market, whether intentionally or unintentionally. It will be interesting, in addition to providing another buying opportunity.