For the Fed, Tapering is No Longer a Matter of If, But When

Now that the central question before the Federal Reserve has shifted from whether to cut its extraordinary stimulus to when exactly to pull back, the debate at next week's meeting will center on how best to communicate that plan.

While recent and brisk improvements in the labor market have raised the chance that policymakers might taper at their meeting next week, most economists expect the Fed to keep its $85 billion-a-month bond-buying program in place for a bit longer.

But the Fed is expected to grapple with how much to telegraph about any plan to wind down its purchases, and to reinforce its commitment to keeping interest rates near zero even as it preps markets for the long road back to policy normalcy.

"What should be on the table is, Are there adjustments to our forward guidance that would reinforce the overall stance of policy that the Fed is trying to communicate?" the president of the Atlanta Fed, Dennis Lockhart, who is often seen as a bellwether for overall U.S. monetary policy, told reporters last week.

Central banks from Washington to Ottawa to Frankfurt have resorted to so-called forward guidance on interest rates in the wake of the Great Recession to convince financial markets they are serious about supporting recovery in the world's top economies for a long time to come.

If investors take central bankers at their word, the theory goes, borrowing costs should stay low enough to allow the economy to make up for lost ground.

To pull the U.S. economy from its worst downturn in decades, the Fed has kept short-term rates near zero. At the same time it has pushed down long-term borrowing costs by buying trillions of dollars in Treasuries and housing-backed securities.

Layered on top of that approach is the forward guidance - a critical and relatively new element in the Fed's strategy to boost investment and hiring.

Since December last year, the Fed has promised not to even consider raising rates until unemployment falls to at least 6.5 percent. Less precise but no less important is the Fed's guidance on asset-purchases - it will keep buying until the labor market outlook improves substantially.

Now that unemployment has fallen to 7 percent, from 10 percent four years ago, change is afoot.

The markets can handle a "small taper," St. Louis Fed President James Bullard, a policy centrist, told a group of investment advisers this week. Even the dovish chief of the Chicago Fed, Charles Evans, said in a recent interview he is "open-minded" to a reduction at the Dec. 17-18 meeting.

In a Reuters poll conducted this week, 32 economists said they expect the central bank to wait until March, while 22 looked for a move in January. Only 12 expected a move next week.

One month ago, however, the figures for January and December were 16 and three, respectively.

"Almost everyone now on the (Fed's policy-setting committee) seems to think a tapering of asset purchases should occur in the next few meetings," said Scott Anderson, chief economist at San Francisco-based Bank of the West. "The focus at the December meeting will likely be around the forward guidance, where there seems to be no clear consensus on next steps.

"I do think they would like to strengthen forward guidance on short-term rates at the same time they start the taper."

TINKERING WITH THE MESSAGE

Policymakers will also discuss the merits of adopting a preset schedule for winding down the Fed's third round of bond-buying since the recession, known as quantitative easing, or QE3.

Four Fed officials have publicly embraced this idea, arguing that doing so would allow markets to digest the policy change more easily. At least two, San Francisco Fed President John Williams and Charles Plosser of the Philadelphia Fed, want to put a cap on QE, which has already swelled the Fed's balance sheet to $4 trillion.

"I'm becoming more sympathetic to the view that once we decide, when we decide, our program has accomplished what we wanted it to do ... that maybe it would be good to announce kind of an end to the program at that point," Williams said in an interview last week.

"I think we can do more work on our forward guidance."

As to when rates will finally rise, half of top Wall Street economists polled by Reuters believe the central bank will retool its low-rate vow to promise no rate hike until unemployment has fallen to 6 percent or lower.

The idea behind lowering the threshold would be to head off a bond-market selloff like that which occurred this past spring in response to hints that the end of QE was close. The selloff pushed long-term borrowing costs to potentially bruising levels and was one reason the Fed did not reduce QE in September.

Fed officials may ultimately shy away from such a move, in part because doing so could complicate an already complicated policy.

Instead, Fed Chairman Ben Bernanke could use stronger and more precise language to stress that easy policies are in place for a considerable period after unemployment hits the 6.5 percent threshold.

A QE taper is now "pretty much priced into the markets, so it shouldn't be a big deal," said Ethan Harris, co-head of global economics research at Bank of America Merrill Lynch.

"I think the more interesting story ... is that the Fed is going to give very dovish directions on policy going forward as a way of addressing very low inflation."

A gauge of core inflation closely monitored by the Fed rose just 1.1 percent over the year through October, well below the central bank's 2 percent target.

As the U.S. central bank looks set to tinker with its language, the debate over forward guidance rages globally.

The Bank of England, for one, has tied a possible rate rise to 7 percent unemployment. "We think it's been effective," BoE Governor Mark Carney said of the guidance on Monday. But "we don't sit here and think we need to reinforce it, except by ... repetition."

Some central bankers have lately cooled to offering precise guidance.

The head of the Bank of Japan, Haruhiko Kuroda, said last week that central banks should avoid offering overly complicated forward guidance on their policies, warning that doing so could prove counter-productive.

"Too complicated forward guidance, or too complicated communication," Kuroda said, "could be less efficient and sometimes even disruptive."