November 4, 2013

Fed is confused and a toothless paper tiger

I describe the market's view of the Fed as a toothless paper tiger based on the fact that the federal funds rate at year-end 2015 is being discounted to 62 basis points vs. the Fed's forecast of 1%.

As I described yesterday in "Happy Halloween From the Fed," I consider Wednesday's FOMC statement as a bunch of wrong-footed and low-quality gibberish.

Clearly, the Fed is now in a bind. The dual mandate would suggest that current monetary policy would stay in place for a lengthy period of time (read: many years). The more the Fed's balance sheet expands, however, the higher the amount of losses to the Treasury down the road. In its extreme, this could pose a risk to the Fed's independence. This issue has been a talking point in academic and policy circles over the past two years -- even the International Monetary Fund cited this risk recently.

Let's review the confusing timeline of Fed tapering commentary in 2013:
On May 22, Humphrey Hawkins questioning Chairman Bernanke's "next few meetings" comment stopped the market's bull run, which had previously behaved as if the notion of tapering was so far out not to matter.
Bernanke's post-June 19 press conference led the markets to trade as though tapering were likely to begin in September. The S&P 500 lost 5% in four trading days, while the bond market suffered a brutal beating (as 10-year U.S. note yields rose from 2.05% to 2.95%).Then Bernanke blinked. Financial conditions tightened as mortgage rates climbed.

So, at the July 10 press conference after the NBER speech in Boston, the Chairman moved toward a very dovish stance, citing a weaker-than-forecast economy. No longer was the unemployment rate of 6.5% a trigger to policy -- there were conditions placed on the jobless rate. But, it seemed to markets that the message was that a September tapering was still on.

The Sept. 19 no-tapering meeting surprised the markets, with only Esther George dissenting.It is clear that the Fed is confused and the markets view our monetary authorities as a paper tiger.
In the extreme, the Fed appears to be almost paralyzed. In all likelihood, the economic data in the near term will be distorted and ambiguous. There is simply not enough clean data for a confused Fed to make policy changes at the December meeting. A January tapering is also unlikely, as it coincides with another debt ceiling negotiation, and this Fed doesn't seem to be in the mood to upset the markets.