Four dilemmas facing the Fed

We expect the Fed to start tapering at the FOMC meeting this week. We expect a very gradual start with only 10bn reduction in the purchases.
On top of tapering, the meeting will include a lot of additional information. Economic projections for 2016, details of the statement and Bernanke’s comments at the press conference will be just as interesting.
In order to keep interest rates in check, the start of tapering will have to be balanced by more dovish signals. This gives the Fed a major communication challenge and we consider below several dilemmas facing the Fed.

Fed dilemma #1: How to taper and still sound dovish

We, along with a wide range of other Fed watchers, expect the Fed to announce the first USD10bn scale-down of its asset purchases at the FOMC meeting on 17-18 September. Admittedly, the weakening trend in payrolls growth over the past three months has increased the possibility that the Fed will push the decision to its October or December meeting. However, we think the Fed will go ahead with the plan and start tapering at a very gradual pace. We expect a 10bn decline in the purchases of treasuries and no change to the mortgage purchases.

The challenge for the Fed and Chairman Bernanke will be to keep market expectations of the fed funds rate path in check and taper at the same time. We have already seen a more than 100bp increase in 10-year treasury yields since May as markets have upped their economic growth expectations and pushed the pricing of the first fed funds rate hike to late 2014/early2015. The increase in mortgage rates has started to dampen housing activity and according to the Fed’s own models the drag on GDP growth from the rate increase seen so far will be significant. Next year, if sustained, the rate increase will subtract almost 1.5pp from growth (see table below). While a lot of other factors are pulling in the direction of better growth, we think the Fed will not want to risk another leg in the sell-off that prematurely pushes longer-term interest rates up and risk the recovery.

Share: Analysis feed

This publication has been prepared by Danske Bank for information purposes only. It is not an offer or solicitation of any offer to purchase or sell any financial instrument. Whilst reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and no liability is accepted for any loss arising from reliance on it. Danske Bank, its affiliates or staff, may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives), of any issuer mentioned herein. Danske Bank's research analysts are not permitted to invest in securities under coverage in their research sector.
This publication is not intended for private customers in the UK or any person in the US. Danske Bank A/S is regulated by the FSA for the conduct of designated investment business in the UK and is a member of the London Stock Exchange.
Copyright () Danske Bank A/S. All rights reserved. This publication is protected by copyright and may not be reproduced in whole or in part without permission.