Surprisingly the Federal Reserve said today that it will keep its USD 85bn-per-month bond-buying programme in place, saying that they wanted to see more evidence that the economy can sustain improvement before scaling back its bond purchases. Fed officials pointed to concerns that financial conditions had tightened in recent months and that those conditions could slow the economy if sustained. Moreover, the Fed seemed increasingly concerned that Congress could soon trigger a government shutdown. However, at the press conference Bernanke said that the Fed still expects to slow down its asset purchases, if the economy develops in line with expectations. ?If it does, we’ll take the first step at some point, possibly later this year, and continue so long as the data are consistent with that continued progress,? the chairman said. Having said that, it seemed that Bernanke was backing away from the Fed?s past comments on the timing of tapering. Thus, Bernanke said today it is ?possible? to taper later this year, but that contrasts with the plan he laid out earlier in the year that the taper could start this year and wind up by mid-2014. He also backed away from saying 7% is likely the unemployment rate that will bring QE to a close. Today he called this unemployment rate an ?indicative number,? showing a Fed that is in no hurry to slow the pace of stimulus. On the fed funds rate, the Fed repeated its forward guidance, saying that it still plans to keep the fed funds rate steady at least until unemployment falls to 6.5%. In the FOMC participants new projections unemployment is seen reaching that level in early 2015, as in June (see chart). Of the 17 participants in today’s policy meeting, 12 expected that it will make sense to start raising rates in 2015 (see chart). However, the projections also show the fed funds rate remaining extremely accommodative even by the end of 2016 – well below the 4% level that the FOMC sees as neutral. By the end of 2016 the FOMC participants see the unemployment rate close to the estimated full-employment level of 5½% and inflation near the 2% long-term target (see table). While a traditional Taylor rule would suggest a fed funds rate around 4% at that point, the median FOMC participant still favours a rate of just 2% by end-2016. (The end-2015 median fed funds rate forecast is 1%, as in June.) This is yet another sign of the dovish shift in the Fed?s policy reaction function and the fact that Bernanke drew attention to this projection is, in our view, a clear indication of the Fed?s commitment to low rates for long. At 2% the median FOMC participant estimate for the fed funds rate is close to the roughly 2% that now appears to be priced into the December-2016 eurodollar futures contract. What next? Despite today?s surprise we believe that tapering will start soon. However, the Fed seems likely to wait until the 17-18 December meeting before making such a decision. Thus the December FOMC meeting is the next time the officials? economic projections will be updated and a post-meeting press conference is scheduled. As noted, the Fed is clearly concerned about the recent surge in market rates and the implications for economic activity, particularly in the housing market. However, we believe that over the next few months we will see more evidence that the recovery will continue to gain more underlying momentum. If we are right, the Fed should feel more confident to start tapering shortly before Christmas.
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