Brokerage Notes on FED: HSBC

Post FOMC
Too risky to taper now
The FOMC chose to delay tapering for four key reasons:
mixed economic data, low inflation, tighter financial
conditions, and near-term fiscal policy risks
Based on our assessment of these factors over the
remainder of this year, we expect the FOMC will decide to
moderate the pace of QE purchases in December
However, downside surprises on these factors have the
potential to postpone tapering into 2014

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The FOMC surprised financial markets today by deciding not to taper its purchases of
longer-term Treasury and mortgage-backed securities. Instead, the Committee said that it
“decided to await more evidence that [economic] progress will be sustained before
adjusting the pace of its purchases.”
We now expect that the FOMC will decide to start moderating the pace of QE purchases
at its December meeting (previously, we looked for tapering to be announced at today’s
meeting). At that time, fiscal policy risks, which appear to have played a part in staying
the Committee’s hand on tapering at this time, should be resolved, and we think the
policymakers should have enough evidence by then of a modest pickup in economic
growth and a rebound in the inflation rate closer to its 2.0% medium-term target.
In deciding not to scale back the pace of QE purchases now, the FOMC put emphasis on
the “tightening of financial conditions observed in recent months.” It appears that the
Committee is pushing back on the rise in longer-term Treasury yields and mortgage
interest rates in the three months since Fed Chairman Ben Bernanke’s June announcement
that the FOMC was intending to moderate the pace of QE purchases. The FOMC appears
to have decided that it was too risky to tighten monetary policy at this juncture, after
financial markets had already appreciably tightened monetary conditions.
Still, the Committee is inclined to cut back on the pace of QE at some point. In its July
statement, the FOMC said that it was “prepared to increase or reduce the pace of its
purchases…as the outlook for the labor market or inflation changes.” That sentence has
been dropped from the latest policy statement and replaced with the following: “In
judging when to moderate the pace of asset purchases, the Committee will, at its coming
meetings, assess whether incoming information continues to support the Committee’s
expectation of ongoing improvement in labor market conditions and inflation moving back
toward its longer-run objective.” The only question in the Committee’s mind, we believe,
is when it will start reducing purchases.

In his press conference, Mr. Bernanke laid down three conditions that would guide the Committee’s
decision for moderating QE in the coming months:
A pickup in economic growth.
An improvement in the outlook for the labor market.
A rise in the rate of inflation closer to the FOMC’s 2.0% medium-term objective.
The important thing to note about these conditions is the inclusion of a rise in inflation back closer to
2.0%. Previously, Fed officials indicated that they felt the decline in inflation earlier this year was
“transitory.” This implied to us that low inflation would not be a barrier to the tapering of QE, as long as
the Committee forecast a rise in inflation in the coming months. Now, it appears that the Committee will
have to see evidence that inflation is actually beginning to increase, before it will begin to moderate QE.
This impression was reinforced during Mr. Bernanke’s press conference when he said that, “The
Committee would be unlikely to increase rates if inflation were projected to remain below our 2%
objective for some time…”
The renewed emphasis on the Committee’s inflation target clouds the outlook for the tapering of QE.
Though the Committee seems inclined to taper at some point, the conditionality surrounding a tapering
appears to have increased.
Aside from the decision not to taper QE at this meeting, the FOMC also sprung another surprise. The
projected path for the Fed funds rate going forward came in somewhat lower than expected. Members of
the Committee generally lowered their view of how high the Fed funds rate would be at the end of 2015
compared to their June assessment. For 2016, the median assessment put the Fed funds rate at 2.0%, less
than indicated by the Fed funds futures market prior to the release of the FOMC’s new forecasts.
The FOMC’s “lower for longer” attitude regarding the Fed funds rate was succinctly summarized by Mr.
Bernanke in his press conference: “Committee participants generally believe that because the headwinds
to recovery will abate only gradually, achieving and maintaining maximum employment and price
stability will require a patient policy approach that involves keeping the target for the Federal funds rate
below its longer-run normal value for some time.” In our view, with this new “forward guidance” on the
Fed funds rate, the FOMC was trying to lean against the recent rise in market interest rates.
In assessing the outlook for growth, unemployment, and inflation in the near term, Mr. Bernanke also put
some emphasis on the risks posed by federal fiscal policy in the near term. Negotiations are underway in
Washington over the required legislation for a FY2014 budget starting in October and the need to raise
the Treasury debt limit. A breakdown in these negotiations could cause some economic disruptions, such
as those that occurred in the summer of 2011. The FOMC has decided that it would be inappropriate to
move to less monetary policy accommodation at this time, when an intensification of fiscal restraint
might occur.
The fiscal policy outlook is indeed a wild card for near-term economic forecasts (see US Budget Battles –
Congressional parties preparing for fiscal showdown, 02 September 2013). Failure to agree on a budget
could lead to a shutdown of some government services, at least temporarily. In addition, the Treasury’s
debt limit would have to be increased, probably by mid-October. If not, there is a possibility – albeit
small – that the federal government could default on some of its financial obligations; the mere specter of
this development could be enough to cause economic and financial market disruptions.
At this stage, our baseline expectation is that at some point over the next month, there will be a resolution
in the fiscal policy debate in Washington that removes these two near-term threats: a government
shutdown, or a default on the government’s financial obligations. If these risks are eliminated, or at least
pushed off into the future, then economic growth may pick up modestly in the fourth quarter.
We expect GDP growth to average about 2.2% in the second half of this year, a slight improvement over
the 1.8% pace recorded in the first half (see US Economic Outlook – Strong second-half rebound looks
elusive, 4 September 2013). That is near the lower end of the FOMC’s new economic forecast range for
GDP growth in 2013. As for inflation, we expect to see the rate of inflation move very slightly higher for
the rest of this year, with the year-on-year core PCE deflator at 1.3% in Q4 this year. This is just a touch
above the FOMC’s updated forecast.
Overall, if the fiscal headwinds diminish, our forecasts suggest that the economic conditions for the
FOMC to start tapering QE will be met in December, but just barely. We would expect a slow start to
tapering, something on the order of USD15bn, split between USD10bn in Treasuries and USD5bn in
mortgage-backed securities.