Monday, December 23, 2013

Taper has started - long live forward guidance

The Fed has made its move and has cut the bond purchase plan by $10 billion a month. The program may end by December 2014. So what does this mean? I don't think any one really knows. So we have a cut of $10 billion but the central bank still buys $75 billion. How does this matter relative to what foreign central banks, hedge funds, and dealers may do?

A gradual change in QE is the only reasonable option for the Fed. A step function makes sense in order to have the market adjust to the change in policy; however, we are not sure when the cuts will start to have a bite on investors. Cutting the balance sheet of the Fed should at some point start to have an impact on excess reserves and rates, but whether at $75 or $25 billion is just a guess. Investors will look for other information to answer the question on rates, and the answer is forward guidance.  The forward guidance is that low rates will continue for much longer that the QE.  

So how is this going to work? The quantity side will change, but trust us the rates will stay low for much lower.  What will be the mechanism for policy? This will be a threat to Fed creditability. It is not clear how policy will work.

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