Tinker taper: the Fed's cautious path

Many within the Fed believe its QE program is becoming less effective as time wears on. But future bumps in the tapering process mean it's prudent for the Fed to keep its options open.

The Federal Reserve minutes released overnight suggest that the central bank will “proceed cautiously” as it unwinds its unprecedented $US85 billion-per-month asset purchasing program. Just how cautious will depend on labour market figures released on Friday night.

The minutes of its December meeting showed that most voting committee members agreed that the recent improvements in the labour market warranted a move to reduce asset purchases from $US85 billion to $US75 billion. But most members want to “proceed cautiously” and stressed that further reductions should be undertaken in “measured steps”.

The Fed reiterated that the taper was not on a “preset course”, which allows the Fed wriggle room to respond to changes in the economic climate as they see fit. While keeping its options open might make for confusing forward guidance, it is also good and prudent central banking.

This much is clear; Asset purchases may remain at a high level if economic conditions warrant it.

In a survey conducted over the intermeeting period, most participants judged that the marginal benefits of the asset purchases were greater than the marginal costs. This indicates that within the Fed, additional purchases are regarded as beneficial for the economy. But it is worth noting that a majority of survey participants also said the marginal effectiveness of purchases declined as purchases continued, indicating that with every additional month, the Fed was getting less bang for its buck.

There are still dovish members of the Fed who are worried that the economy is not strong enough yet to give up on quantitative easing and a few voting members suggested the Fed should lower the unemployment rate threshold used in its forward guidance to 6 per cent (down from 6.5 per cent). As the vote to reduce bond purchases suggests, most members believe that this was unnecessary.

So expect US interest rates to rise. Currently two-thirds of participants in the Fed’s forecasts believe it will begin raising interest rates in 2015. By that point, the Fed expects the unemployment rate to decline to between 5.8 and 6.1 per cent.

Between the unwinding of its asset purchases and its forward guidance, it will be tricky to predict the Fed’s actions in 2014. My general view at the moment is that it will continue to taper throughout the year and, by the end of 2014, the asset purchasing program will be largely finished. But that view relies on inflation picking up and heading back towards expectations.

If inflation fails to eventuate then the Fed will obviously cease to taper. Although the economy has clearly improved, we should not underestimate the many road bumps that the Fed will have to navigate as it unwinds its purchases.