The Taper Tale

The impact from yesterday's announcement following the 2-day Federal Open Market Committee (FOMC) meeting was different this time.

Past announcements from Ben Bernanke, Chairman of the Federal Reserve Board, in which there was even a hint of an impending draw-back of monetary stimulus (so-called "tapering" of the Fed's bond-buying program) were typically followed by a significant sell-off in the financial markets. Thus, for example, the Dow Jones Industrial Average dropped by as much as 3-5% in the few days after each of the July, September and October FOMC meetings. Each time, markets began to get a sense that tapering was just around the corner, and thus responded negatively, a reaction dubbed the "taper tantrum".

But yesterday, past tantrums turned into a big rally. Once Chairman Bernanke began his press conference at 1:50PM (his last as Chairman as he is succeeded by Janet Yellen next year), the Dow began climbing, closing the day some 292 points, or 1.8%, higher. Even long-bond yields dropped initially, though their upward trend has resumed today as bonds have sold off somewhat. Instead of just hints, the Chairman announced that tapering will in fact begin, next month, in a modest way, with the Fed reducing its monthly purchases of bond and mortgage-backed securities, by $5 billion for each, lowering total purchases from $85 to $75 billion per month. Moreover, tapering would likely continue after future meetings in "measured steps", but such would be data dependent, with no preset plan. Tapering is not tightening, the policy statement asserted, and short-term interest rates will not be raised until 2015 at the earliest, when the unemployment rate is expected to fall below the Fed's threshold of 6.5%. Indeed, in a new line in the statement, Mr. Bernanke noted that the Fed will likely keep the fed funds rate near zero "well past" the time when the jobless rate reached 6.5%. It appears it was precisely this very dovish forward guidance that the markets found so bullish.

The wild card of sorts in determining future Fed policy is inflation. Yesterday's policy statement included this new emphasis: "The Fed recognizes that inflation persistently below its 2 per cent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that it will move back toward its objective over the medium term". In other words, the Fed is clearly concerned about very low and falling inflation - that is, disinflation - as the threat of such a trend is that it can morph into outright deflation. It is extraordinary that, despite the Fed's program of quantitative easing, injecting massive amounts of money into the economy, inflation has continued to fall. Economists explain this by noting that most of the injected stimulus cash has remained in the form of banks' excess reserves, because demand for credit is still tepid, and because its supply is deliberately constrained by cautious bank lending practices. In their jargon, money velocity is very low.

Stay tuned over the next several months, as it may well be that inflation trends, much more than changes in unemployment, become the principal criteria for the timing and amount of further tapering. It's certain that if inflation falls more, tapering will stop, and may be reversed. As the Fed has said many times, it's all data dependent.