Brokerage Notes on FED: UBS

The Fed Balks
„ “Await[ing] more evidence that progress will be sustained…”
The FOMC on September 18 decided to maintain its current purchase program at
$85 billion per month. The policy statement noted that the “Committee decided to
await more evidence that progress will be sustained before adjusting the pace of its
purchases”. In putting off a tapering, the Fed surprised market participants, the vast
majority of whom expected a modest taper at this meeting.
Chairman Bernanke after the announcement cited two key risks: the ongoing fiscal
drag and the tightening of financial conditions. Regarding fiscal policy, he noted
that “a factor that did concern us in our discussion was some upcoming fiscal
policy decisions. I would include both the possibility of a government shutdown,
but also the debt limit issue.” In the FOMC statement, the committee noted that
“the tightening of financial conditions observed in recent months, if sustained,
could slow the pace of improvement in the economy and labor market.”
„ Resetting the clock to Q1
The budget concerns suggest that the Oct. 29-30 meeting may be too soon for the
Fed to begin the long-awaited tapering of quantitative easing as negotiations may
still be ongoing. Also, we believe the Fed would prefer to avoid a Dec. 17-18
meeting tapering that could be viewed as too risky in the midst of the key holiday
shopping season. In our view, particularly now that any Fed warnings regarding a
taper are likely to be discounted by market participants, there are higher odds of a
disruptive sell-off in equity markets in response to a taper announcement.
As a result, we now believe that the Fed will not begin tapering until the first
quarter of 2014, with the January 28-29 FOMC meeting somewhat more likely
than the March 18-19 meeting. Chairman Bernanke stressed that policy changes
need not take place at meetings with press conferences (and updated forecasts), an
argument that was also supported by the statement language. By late January
economic conditions are likely to be showing the economy improving at a pace
that would likely allow them to claim that conditions are now ripe for a tapering of
policy. However, an earlier budget resolution, an acceleration in payroll growth
and a sustained decline in 10-year yields (to 2.50%) could result in an earlier taper.
With tapering delayed, the expected termination of overall Fed balance sheet
expansion now looks like the end of next year instead of mid-year. Accordingly, the
first fed funds rate hikes now appear likely only in mid-2015 rather than the start
of the year.
The constructive near-term bond market effects of these changes in the Fed
outlook re-enforce our confidence that annual average real GDP growth will
pick up next year to 3.0%.

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The Fed Who Cried Wolf
The Federal Reserve passed on an unusual opportunity: to begin the exit from
quantitative easing without a potentially destabilizing market response. Indeed,
a CNBC poll suggested that market participants felt that a taper was largely
“priced in”, a view that seems reasonable given the market response to the
decision not to taper. We would note that opportunities such as the one offered
to the Fed today are rare: to date no central bank that has ever begun quantitative
easing has been able to exit from those policies. The FOMC may come to regret
passing on this opportunity. Like starting families and moving, there is usually
not a perfect time to change policy.
A consequence of this inaction may be that the market will view future Fed
communications with some scepticism. We have argued repeatedly that
introducing some uncertainty into the Fed’s decision-making process could
actually support the Fed’s goals. However, we viewed increasing the uncertainty
with regard to the process, not to the goals themselves. The Fed’s actions today
reduce both the transparency the Fed has argued supports their goals AND the
clarity of their goals, the latter being more significant as it could cause an
unwelcome increase in volatility. This is likely to prove costly when the Fed
finally does move to taper.
The updated central tendency projections continued to show stronger growth in
the next couple of years; gradually rising (but still-tame) inflation; and a
continued decline in unemployment;. (