The Fed and Tapering -- Anybody's Guess

Everyone seems to have a strong opinion on what the Federal Reserve will announce Wednesday following this week’s two-day meeting of the policy-setting Federal Open Market Committee. But no one knows for sure.

The Fed has shown a knack for keeping the markets guessing.

Will they announce a reduction in their monthly $85-billion-a-month bond purchase program or won’t they?

Peter Cardillo, chief market economist at Rockwell Global Capital, says they will.

“They’ll announce tapering tomorrow and they’ll upgrade their economic outlook. They’ll indicate that finally the economy is beginning to run on all gears,” Cardillo said Tuesday. “This would be a clear message that the Fed is not worried about the economy -- that the economy is doing well and doesn’t need help anymore.”

Cardillo said FOMC policymakers are likely concerned about a Fed balance sheet that is approaching $4 trillion as a result of the asset purchase programs known as quantitative easing begun five years ago in the wake of the 2008 financial crisis.

“It’s getting really hefty,” he said.

The timing is right, according to Cardillo, because the Fed has been telegraphing a reduction in its easy-money programs for months but has held off until the economy showed sustained momentum.

Conventional wisdom in the fall held that a sharp market selloff would follow a tapering announcement, as investors mourned the loss of easy money. But Cardillo believes that won’t happen Wednesday because markets have already priced in tapering.

Besides, the tapering will be “limited” – a reduction of $8 billion to $10 billion per month, he predicted, “to see how the markets handle it.”

Not everyone agrees that tapering will commence later this month.

Despite the “strong logical case for phasing-out QE,” David Kelly, chief global strategist at JPMorgan Funds, said the feeling among many Wall Street investors is that the Fed will wait another month before tapering.

Avoiding the 'Tough Decision'

“This Federal Reserve has proven itself to be among the most dovish in history,” Kelly wrote in a note to clients. “Because of this, many investors continue to believe that they will avoid the tough decision for at least another meeting.”

Kelly’s “logical case” for scaling back QE sooner rather than later includes a reduction in the unemployment rate from 7.8% in September 2012, when the Fed initiated its latest round of bond purchases, to 7% in November as the economy added 2.3 million jobs in that 14-month period.

“While logically the decision to taper on Wednesday shouldn’t be a close call, in practice it is.  If the Fed does decide to reduce bond purchases, we might well see long-term rates rise, the dollar appreciate and stocks fall, although the latter reaction could be short-lived,” Kelly said.

The Fed has made it clear that a healthy labor market is its top priority and its stimulus programs – QE and near-zero interest rates – were designed to spur lending to create demand for goods which will in turn generate jobs. How successful the programs have been remains an open question.

Kelly noted that GDP (gross domestic product) growth has accelerated in 2013 and that last week’s bi-partisan budget agreement in Congress, which eliminates some mandated budget cuts known as sequester and could preclude additional budget standoffs for a couple of years, add to the argument for immediate tapering.

Kelly said the Fed’s criteria for tapering, established over the past year, seems to have been filled. “For the Central Bank to maintain its credibility, its words of the last year should mean something, and it should thus begin to reduce bond purchases now,” he said.

The Fed has surprised markets in the past, notably in September when virtually everyone believed tapering would begin, but the Fed maintained easy money. Then Congressional bickering shut down parts of the government in early October and raised the threat of a U.S. default, and the September jobs report, released three weeks late because of the shutdown, was disappointing.

So it was no surprise when the Fed held off again after its October meeting. The two most recent labor reports for October and November have been strong – more than 200,000 new jobs each month -- however, so tapering is squarely back on the table.