The Federal Reserve has been under fire lately for providing conflicting signals on its outlook for the economy and its plans for quantitative easing. Yesterday, the Fed attempted to respond to both concerns. But the reaction of the bond market may not be what they were hoping for.
Heres what we took away from a busy day:
The Federal Open Market Committee (FOMC) held unchanged its current asset purchase program of $85 billion per month and repeated that it is prepared to increase or reduce the pace of its purchases as the outlook for inflation and employment changes. Fourteen of the 19 FOMC members expect funds rate increases to commence in 2015; this majority increased by one from the March FOMC meeting.
There were two dissents for different reasons. President Esther George of the Kansas City Fed remains concerned about future economic and financial imbalances, while President James Bullard of the St. Louis Fed is worried about low inflation and would have preferred the Fed to signal more strongly its willingness to address recent moderation in the price level.
At the outset of the press conference that followed, Chairman Ben Bernanke described the criteria for tapering and terminating asset purchases (emphasis added):
Going forward, the economic outcomes that the Committee sees as most likely involve continuing gains in labor markets, supported by moderate growth that picks up over the next several quarters .
If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year; and if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear.
This is clever phrasing. It offers more specifics on timing, while stressing that any action remains dependent on economic data. He added that a strong majority of the FOMC does not favor selling mortgage-backed securities during the process of normalizing policy, likely to ensure that the housing market continues to benefit from modest mortgage rates.
The Feds updated economic projections present a more sanguine outlook for the economy than the forecast published in March. Real gross domestic product (GDP) is now expected to grow 2.3% 2.6% in 2013 (a small downward revision from the 2.8% upper end of the forecast range) and gather momentum in 2014 to register growth of 3.0% 3.5%. A reduced fiscal drag was cited as one key contributor to the prospective improvement.
The FOMC expects the unemployment rate to decline to about 7.2% by year-end and gradually touch a range of 6.5% 6.8% by the close of 2014. The critical 6.5% mark of the jobless rate, which is the threshold for considerations of interest rate increases, was previously predicted to occur in 2015.
The Fed revised its inflation forecast for 2013 to 0.8% 1.2% from 1.3% 1.7% in April but left the 2014 prediction mostly unchanged at 1.5% 2.0%. Chairman Bernanke noted that transitory factors, such as lower health costs related to federal budget sequestration and costs of imputed financial services, shown above, are holding down inflation readings. As these fade, so should any concern about deflation.
The upgrade in the outlook for the economy triggered a bond market sell-off, taking the 10-year Treasury note yield to above 2.40% as of this writing from 2.20% just prior to the chairmans remarks. Investors apparently focused more on the forecast upgrades than Bernankes careful message that an easing of the accelerator is not equivalent to a tapping of the brake.
Chairman Bernankes opening remarks were a solid attempt to clarify the meaning of last months comment that tapering could begin in the next few meetings, which had left financial markets confused. We viewed yesterdays communication as an improvement, but the picture of improving fundamentals sustained a negative tone for bond markets. This could be a hot summer for investors and Fed watchers alike.