QE Tapering This Year But At Moderate Pace‏

Overall the message from Ben Bernanke was consistent with his earlier comments that QE tapering could start within the next few meetings but was interpreted as more hawkish than expected by markets.

• In our view, there are three key reasons for that. First, there was no mentioning of declining inflation expectations in the statement and at the press conference Bernanke did not sound worried about the recent developments. Second, the statement said that “Downside risks to the economic outlook have diminished since the fall”. This is also evident in the economic projections, where GDP growth for next year was marked up a notch and unemployment marked down. Third, Bernanke was surprisingly explicit in talking about QE tapering, stating that tapering may start later this year and asset purchases come to an end mid next year IF the economy develops in line with the committee’s expectations.

• Bernanke had some interesting points about QE. With regard to why there is a difference between QE and rate hikes, he stated that QE is an unconventional policy tool that can have unwanted effects. In terms of ending asset purchases Bernanke said that an unemployment rate of 7% and improved growth would mark a "substantial improvement" and hence QE should end. He expected these conditions to be met mid next year. His remarks about starting tapering later this year but not ending it until mid 2014 also suggest that tapering will be very gradual. Assuming that tapering starts in September and ends in July next year, the pace will be around 15bn reduction per meeting.

• Obviously, the FOMC did not succeed in convincing markets about the disconnection between the Fed funds rate and the timing of ending asset purchases. This despite the projections of the timing of the first Fed funds rate hike was actually more dovish. Only three members compared to four in March expected the first hike in 2014 and 14 compared to 13 in March saw the first hike in 2015. In addition, the average projected level of the Fed funds rate by end 2014 was lowered from 1.35% to 1.13% and for 2015 to 1.07% from 1.36%. Nevertheless, 10-year treasury bond yields spiked 10bp following the meeting and 2-year yields 6bp.

• Finally, in his prepared remarks Bernanke finally made official that the Fed will not actively sell its holding of mortgage backed securities as part of its exit strategy but keep all of its assets, both MBS and treasuries, to maturity.

• The likelihood of the Fed starting its tapering already in September is likely closer to 75% than our previous estimate of 50% but of course remains dependent on labour market developments. However, it does seem that the pace of job growth needed to begin tapering is likely below the 200,000 level we previously thought and probably closer to 160,000/170,000 on average over the coming three months. Stay tuned.

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