Viewpoint : Fed preparing the scene to start reducing bond purchases gradually and cautiously

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The main points of the latest communication are:

1) the Fed will act cautiously and gradually in managing changes, keeping monetary policy highly accommodative and dependent on forthcoming data;

2) while further information on the outlook will be gathered before touching QE3, purchases are likely to be reduced gradually starting sometime during the summer, although the Fed will be ready to change its strategy in function of the data. The Fed is keen on reassuring the markets with regard to its commitment to supporting the recovery and limiting volatility.

Bernanke, in his testimony before the Congress’s Joint Economic Committee, was again cautious in assessing the state of the economy, remarking that the job market has improved but remains “weak overall”. As regards monetary policy, Bernanke repeated that the Fed is prepared to increase or reduce the pace of its asset purchases to ensure that the monetary policy stance remains appropriate as the outlook for the labour market or inflation changes. Bernanke stressed that a premature tightening of monetary policy could carry the risk of ending the recovery and further compressing inflation below the Fed’s target. Reference to the risk of excessive tightening is not tied to the reduction in the pace of purchases, which is still equivalent to an increase in monetary accommodation, albeit at a slower pace. Tightening may come from a reduction in the size of the Fed’s balance sheet, which would occur by not reinvesting assets reaching maturity, after QE3 purchases have stopped.

Answering direct questions, Bernanke said that the Fed may consider reducing the programme “in the next few meetings”, on condition of the positive trend of the economy being confirmed. The chairman declined to answer a specific question on the exact date of the first move (before Labour Day?). As expected, some light was shed on the timing of the slowing of purchases by the May FOMC minutes, which laid bare a wide range of opinions, but also consensus on some important points. Most participants agreed on the fact that the labour market has improved, although “many” of the latter believe further confirmation is needed that progress is on-going, that risks are easing, and that there is confidence in the outlook, before the flow of purchases should be modified. “A number” of participants are ready to reduce the pace of purchases already in June, if fresh data confirm that growth is “sufficiently strong and sustained”. This is where a balance must be sought between the “many” participants who prefer to await further data, and those who are ready to reduce purchases already in June. The former clearly outnumber the latter, and the extra information that will be available by mid-June compared to the beginning of May is not so substantial, limited to two employment reports, of which one already disclosed. Other data releases in the present phase are still proving mixed. In light of recent statements, of the minutes, and of economic data, we believe that at its June meeting the FOMC will signal that it intends to analyse further data as they become available in the months ahead, to confirm that the outlook for the labour market has improved “substantially”, while indicating that the it may probably be possible to start reducing the programme in the summer. However, it will be clearly specified that such a reduction will still be equivalent to an increase in monetary accommodation and that the monetary policy path is data-dependent.

At its June meeting, in addition to the timing and calibration of the reduction of purchases, the FOMC may also discuss its exit strategy. Dudley said that the FOMC intends to “revisit” its exit strategy and communicate it as transparently as possible, in order to reduce potential excessive volatility once the pace of monthly purchases is reduced. The new exit strategy guidance may specify that 1) the balance sheet will remain large for an extended period following termination of QE3, and that 2) the Fed does not intend to sell assets held in its portfolio, but is planning a gradual exit in step with the natural maturity of the bonds held in its portfolio.

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