(Four) Three 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 $10 billion 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 $10 billion decline in the purchases of treasuries and no change to the mortgage purchases (see also Flash Comment – US: Weak job growth opens door for October start to tapering).

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 risks the recovery.

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