Why the Federal Reserve Continued to Taper in April

The Dow Jones Industrial Average (DJINDICES: ^DJI  ) was little changed this week after the Federal Reserve announced another $10 billion taper of the quantitative easing program. After every Federal Open Market Committee meeting the panel releases a statement detailing its thinking on the economy and the actions it plans to take on interest rates and asset purchases. The market always eagerly awaits these statements, as interest rates play a large role in determining the value of all other assets.

The April FOMC statement came out earlier this week, and the big news was that starting in May, the Fed will purchase only $45 billion per month in long-term assets -- $20 billion worth of mortgage-backed securities and $25 billion in long-term Treasury bonds -- rather than the current $55 billion.

There was minimal change in the most recent statement, and the important point to note is that the Fed is optimistic about the economy going forward and believes this week's low Q1 GDP numbers were a result of the harsh U.S. winter.

Let's dissect April's statement and compare it with March's. The emphasis is mine and indicates a change from the previous statement.

March 18-19 2014

April 29-30 2014

Information received since the Federal Open Market Committee met in January indicates that growth in economic activity slowed during the winter months, in part reflecting adverse weather conditions.

Information received since the Federal Open Market Committee met in March indicates that growth in economic activity has picked up recently, after having slowed sharply during the winter in part because of adverse weather conditions.

Labor market indicators were mixed but on balance showed further improvement. The unemployment rate, however, remains elevated.

Labor market indicators were mixed but on balance showed further improvement. The unemployment rate, however, remains elevated.

Household spending and business fixed investment continued to advance, while the recovery in the housing sector remained slow.

Household spending appears to be rising more quickly. Business fixed investment edged down, while the recovery in the housing sector remained slow.

Fiscal policy is restraining economic growth, although the extent of restraint is diminishing.

Fiscal policy is restraining economic growth, although the extent of restraint is diminishing.

Inflation has been running below the committee's longer-run objective, but longer-term inflation expectations have remained stable.

Inflation has been running below the committee's longer-run objective, but longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the committee seeks to foster maximum employment and price stability.

Consistent with its statutory mandate, the committee seeks to foster maximum employment and price stability.

The committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and labor market conditions will continue to improve gradually, moving toward those the Committee judges consistent with its dual mandate.

The committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace and labor market conditions will continue to improve gradually, moving toward those the Committee judges consistent with its dual mandate.

The committee sees the risks to the outlook for the economy and the labor market as nearly balanced.

The committee sees the risks to the outlook for the economy and the labor market as nearly balanced.

The committee recognizes that inflation persistently below its 2% objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.

The committee recognizes that inflation persistently below its 2% objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.

The committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.

The committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.

In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the committee decided to make a further measured reduction in the pace of its asset purchases.

In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the committee decided to make a further measured reduction in the pace of its asset purchases.

Beginning in April, the committee will add to its holdings of agency mortgage-backed securities at a pace of $25 billion per month rather than $30 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $30 billion per month rather than $35 billion per month.

Beginning in May, the committee will add to its holdings of agency mortgage-backed securities at a pace of $20 billion per month rather than $25 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $25 billion per month rather than $30 billion per month.

The committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction.

The committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. 

The committee's sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the committee's dual mandate.

The committee's sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the committee's dual mandate.

The committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.

The committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.

If incoming information broadly supports the committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the committee will likely reduce the pace of asset purchases in further measured steps at future meetings.

If incoming information broadly supports the committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the committee will likely reduce the pace of asset purchases in further measured steps at future meetings.

However, asset purchases are not on a preset course, and the committee's decisions about their pace will remain contingent on the committee's outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.

However, asset purchases are not on a preset course, and the committee's decisions about their pace will remain contingent on the committee's outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.

(5) To support continued progress toward maximum employment and price stability, the committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.

To support continued progress toward maximum employment and price stability, the committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate.

In determining how long to maintain the current 0% to 1/4% target range for the federal funds rate, the committee will assess progress -- both realized and expected -- toward its objectives of maximum employment and 2% inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.

In determining how long to maintain the current 0% to 1/4% target range for the federal funds rate, the committee will assess progress -- both realized and expected -- toward its objectives of maximum employment and 2% inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.

The committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the committee's 2% longer-run goal, and provided that longer-term inflation expectations remain well anchored.

The committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the committee's 2% longer-run goal, and provided that longer-term inflation expectations remain well anchored.

(6) When the committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2%.

When the committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2%.

The committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the committee views as normal in the longer run.

The committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the committee views as normal in the longer run.

With the unemployment rate nearing 6 1/2%, the committee has updated its forward guidance. The change in the committee's guidance does not indicate any change in the committee's policy intentions as set forth in its recent statements.

 

Voting for the FOMC monetary policy action were Janet L. Yellen, chair; William C. Dudley, vice chairman; Richard W. Fisher; Sandra Pianalto; Charles I. Plosser; Jerome H. Powell; Jeremy C. Stein; and Daniel K. Tarullo.

Voting for the FOMC monetary policy action were: Janet L. Yellen, chair; William C. Dudley, vice vhairman; Richard W. Fisher; Narayana Kocherlakota; Sandra Pianalto; Charles I. Plosser; Jerome H. Powell; Jeremy C. Stein; and Daniel K. Tarullo.

Voting against the action was Narayana Kocherlakota, who supported the sixth paragraph, but believed the fifth paragraph weakens the credibility of the committee's commitment to return inflation to the 2% target from below and fosters policy uncertainty that hinders economic activity.

 

Last year in every statement the Federal Reserve said that "the current exceptionally low target range for the federal funds rate of 0% to 1/4% will be appropriate at least as long as the unemployment rate remains above 6 1/2%, inflation between one and two years ahead is projected to be no more than a half percentage point above the committee's 2% longer-run goal, and longer-term inflation expectations continue to be well anchored." After harping about the 6.5% unemployment rate target for so long, last month the Fed moved away from a specific target, and this month it removed all talk of the target (the last sentence).

The reason was that the target was no longer valid, as unemployment hit 6.6% in February, perilously close to the Fed's target. After a positive jobs report, unemployment fell to 6.3%. While previous years' statements would have you think the Fed would begin raising rates now, it has no intention of doing so anytime soon. Per the statement and Janet Yellen's speeches over the past month, the Fed seems committed to its zero-interest-rate policy at least until mid-2015, if not longer.

While the Federal Reserve is lowering its monthly asset purchases by $10 billion to $45 billion a month, it still has a massive $4.3 trillion balance sheet, and including the reinvestment of coupons, the Fed is adding to it at a rate of nearly $60 billion a month. 

US Federal Reserve Total Assets Chart

US Federal Reserve Total Assets data by YCharts

Banks are currently the prime beneficiaries, and savers the main losers, of the Fed's policies to keep short-term interest rates low. The Fed is trying to boost the housing market and push up asset prices by forcing savers to invest their money in risky assets. This has proved successful in boosting the stock market and most asset classes, hopefully creating a wealth effect where people are more likely to spend money, but it hasn't been able to keep long-term mortgage rates low. Overall, it's questionable whether the Fed's policies have been successful in boosting the economy, as with all this stimulus the economy is barely growing.

What the Fed's policies have done is to boost asset prices, with the S&P 500 up 30% last year. When interest rates are low, investors try to earn some return by investing in any opportunities that provide some return, while not focusing as much on the risks of the investment. This creates a self-reinforcing trend of rising asset prices to the point where current prices seem likely to lead to negative real returns over the long run for the broader market.

The current market reminds me of the parable David Foster Wallace shared in a 2005 commencement address.

There are these two young fish swimming along and they happen to meet an older fish swimming the other way, who nods at them and says, "Morning, boys. How's the water?" And the two young fish swim on for a bit, and then eventually one of them looks over at the other and goes "What ... is water?"

... The point of the fish story is merely that the most obvious, important realities are often the ones that are hardest to see and talk about.

The important reality that is hardest to see and talk about is that the economy is slowly growing on the back of massive stimulus from the Federal Reserve at the same time that the stock market looks expensive, leading to unknown risks for financial markets going forward.

While prices move all about, macro themes don't really change day to day, so I end with my usual reminder: It's hard to stay sober while everyone around you is drunk on Fed-stimulus punch, telling you to join in on the fun. My advice is to keep learning, focus on your goals, have an investing plan, stick to it, and ignore the crowds.

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