Reading between the lines of the Fed's cautious communication

Normalisation of US monetary policy is likely to become a reality next year, but the Federal Reserve remains cautious in communicating this to markets for fear of sending investors rushing for the exit.

The release of the US Federal Reserve board’s Open Market Committee’s latest policy statement didn’t cause convulsions in markets, but it did generate a few tremors.

The absence of any change to the committee’s forward guidance on US official interest rates -- it left in place the phrase that its target range would probably remain unchanged "for a considerable time" after its asset purchasing program ends -- probably explains why the markets were only mildly impacted by the statement.

US bond rates did, however, edge up; there was some volatility in sharemarkets; the gold price was down; and the US dollar strengthened against most of the major currencies. The Australian dollar was forced back quite sharply below US90 cents and the Japanese yen was trading at its lowest levels relative to the US dollar in seven years.

There may not have been a re-run of the 'taper tantrums' experienced in May last year when then Federal Reserve Chairman, Ben Bernanke, first foreshadowed a winding back of the Fed’s then $US85 billion a month program of bond and mortgages purchases. But the ripples through markets in response to the statement do tend to highlight their sensitivity to even highly-nuanced changes in the Fed’s language.

Last May, US bond yields surged, and there was a rush to the exits from riskier markets as carry trades were unwound. It was regarded as a preview of potentially far larger shifts in capital flows if and when the Fed did start winding back its unconventional monetary policies.

As it happens, the markets have digested the steady $US10 billion-a-month reduction in the size of the asset purchases from $US85bn a month to $US25bn ahead of last night’s statement. The purchases will now be reduced to $US15bn next month, with the program likely to be terminated at next month’s Open Market Committee meeting.

The impact of the latest statement on markets probably relates to some fine-tuning of the committee members’ expectations of where the US federal funds rate will be over the next couple of years.

Fourteen of the 17 members of the committee now expect the first firming of official rates to start next year. The median expectation of where the Fed Funds rate will be over the next few years be rose 25 basis points to 1.375 per cent by the end of 2015, 37.5 basis points to 2.875 per cent at the end of 2016 and was expected to reach 3.75 per cent by the end of 2017.

That suggests more confidence in the strength of the US recovery but could also be interpreted as a signal that the majority of the committee may be edging towards an expectation of an earlier start to the firming of monetary policy and the first increase in rates than they had previously thought likely. The markets have been focused on a shift in US policy from around the middle of next year.

There have been consistent voices within the committee warning of the potential for adverse unintended consequences from the protracted, and quite massive, experiment with unconventional measures. The Fed’s balance sheet has expanded by about $US3.5 trillion since the program began in late 2008.

There’s no doubt that the deluge of ultra-cheap liquidity from the Fed, and indeed within Europe and Japan, has pushed up the prices of risk assets around the globe and has seen capital pour into markets (including our own) that offer positive returns.

The fear is that when the markets are convinced that a US rate rise is imminent, those flows will be reversed, with capital pouring out of developing economies, eurozone bonds and other riskier assets and being repatriated to the US.

The crack in the Australian dollar in response to last night’s statement shows how sensitive it is -- and how sensitive our equity and bond markets might be -- to a real re-run of last year’s taper tantrum. However, the real danger lurks in what might happen to the cost of government debt in the eurozone (where economies and the financial system are weak and fragile) and perhaps in the impact that a violent shift in capital flows would have on emerging market economies and markets.

The moment when 'normalisation' of US monetary policy begins is getting closer but in much of the rest of the world, economies and monetary policy settings are still anything but normal.

The Fed would be very aware of that and of the need for it to be very cautious in its language and in the timing and nature of its normalisation of policy settings.

Last night’s statement was important for what it didn’t say or change. At some point in the not-too-distant-future, however, there will be a shift in the Fed’s language. The implications for markets and economies -- whether there’s significantly more downside than upside -- will become clearer.