David Joy:More confusion from the Fed

There is no question that the Fed’s decision not to commence tapering at its September meeting came as a surprise. Polls conducted just prior to the meeting showed that 70% of investment professionals expected the Fed to do so. Although no one likes to hear it, there was obviously a certain amount of groupthink involved in that 70%.

But the Fed was also complicit in catching investors off guard. Fed officials had indicated that a pullback was likely to begin in the fall, and end in the middle of next year. With the conclusion of last week’s meeting, there are only six more Federal Open Market Committee meetings between now and June of next year. It seemed reasonable to identify the September meeting as the likely start.

On the other hand, in its defense, the Fed never identified a specific date that it was projecting, and had said repeatedly that its decision was data dependent. And certainly, the recent data had been ambiguous, allowing the Fed the cover to justify whatever decision it deemed most prudent.

But the Fed’s communication of its decision, especially the reasoning for it, contains some confusing messages, if not contradictions. And its decision potentially represents a missed opportunity.

In response to a question at Wednesday’s press conference from Victoria McGrane of Dow Jones Newswires about whether the Fed was sending mixed signals to markets, Chairman Bernanke said, “We try our best to communicate to markets — we’ll continue to do that — but we can’t let market expectations dictate our policy actions. Our policy actions have to be determined by our best assessment of what’s needed for the economy.”

However, during his prepared remarks at the start of the press conference, in explaining the FOMC’s decision not to taper, Bernanke also said the following: “The tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and the labor market. … Moreover, the Committee has some concern that the rapid tightening of financial conditions in recent months could have the effect of slowing growth.”

What he is apparently referring to when talking about financial tightening is the rise in market interest rates since he first spoke about the possible trajectory of tapering back in May. If the increase in yield on the ten-year Treasury note during that time from 1.60 to 2.90% is not the very definition of market expectations, then it is unclear what is.

The Fed cannot have it both ways. The whole point of quantitative easing is to manage market expectations regarding interest rates, and thereby impact economic activity. To say that the Fed’s decision function for altering the pace of quantitative easing is not influenced by market expectations is to deny the very reason for its existence.

It seems the Fed simply misjudged the extent of the market reaction to its communications in May, and is now concerned that the subsequent rise in rates may present too much of a headwind for an economy that otherwise is not especially robust, and therefore to taper now is too risky.

So what happens next? If the Fed wants out of QE by the middle of next year, and wants to do so at a pace that is not disruptive to markets, despite its protestations of ambivalence, it needs to start soon.

On what basis will they make such a determination? What if the pace of job creation remains at its recent pace? Is that enough to justify tapering if the ten-year yield stays at its current rate of 2.75%, having declined after the Fed’s announcement last Wednesday? If not, is the Fed comfortable with the possibility of QE infinity?

This gets us to the missed opportunity. Markets were prepared for the Fed to announce a modest degree of tapering last week. It could have done so with minimal reaction, begun the path toward policy normalization, and enhanced its credibility. Instead, the Fed’s communication is muddied, its future leadership is uncertain, QE remains in place, and the Street is confused.

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