June 20, 2013

Market Spooked as Fed Eyes Tapering

By Central Bank News

 The U.S. Federal Reserve maintained its target for purchasing assets worth $85 billion a month but turned slightly more optimistic about the economic outlook and plans to cut back it asset purchases later this year, saying downside risks to the economy had diminished.

     While the Federal Reserve maintained its statement on how and when it may begin to reduce its asset purchases - an issue that has roiled global financial markets since late May - Chairman Ben Bernanke later told a press conference that purchases would be cut back later this year if the economy continues to improve.

    "The Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year; and if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear," Bernanke said.

    At that point, Bernanke said he expects the unemployment rate to be around 7.0 percent and solid economic growth supporting further improvement, he said.

    Bernanke, however, noted that the Federal Reserve was not fixed on any dates and if  "conditions improve faster than expected, the pace of asset purchases could be reduced more quickly." Conversely, if the economic outlook deteriorates, the reductions in purchases could be delayed.

    The Federal Reserve's policy-making body, the Federal Open Market Committee (FOMC) repeated from its May statement that U.S. economic activity was expanding at "a moderate pace" with labor market conditions improving but the unemployment rate remains elevated. Household spending, business investment and the housing sector has strengthened further, "but fiscal policy is restraining economic growth."

    "The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished since the fall," the Federal Reserve said, a slightly more optimistic view compared with May when it said that it "continues to see downside risks to the economic outlook."

    In its latest economic forecast, the Federal Reserve forecasts the unemployment rate to ease to between 7.2-7.3 percent this year, slightly down from the March forecast of 7.3-7.5 percent, and then to decline further to 6.5-6.8 percent in 2014, down from its previous forecast of 6.7-7.0 percent. In 2015 the Federal Reserve forecast unemployment of 5.8-6.2 percent, down from 6.0-6.5 percent.

    Unlike most central bank's, the Federal Reserve is mandated to foster maximum employment and price stability, and intends to keep its key policy rate, the federal fund's rate, at zero to 0.25 percent "at least as long as the unemployment rate remains above 6-1/2 percent," and inflation does not exceed the central bank's 2.0 percent goal by more than half a percentage point.  

     The U.S. unemployment rate inched up to 7.6 percent in May from 7.5 percent in April, but it has been declining steadily from over 9 percent. The inflation rate rose to 1.4 percent in May from 1.1 percent in April and is forecast by the Federal Reserve to remain below 2.0 percent through 2015.

    The forecast for economic growth this year was trimmed to between 2.3 and 2.6 percent, down from the March forecast of 2.3-2.8 percent but the 2014 forecast for Gross Domestic Product growth was raised slightly to 3.0-3.5 percent from a previous 2.9-3.4 percent while the 2015 forecast was trimmed to 2.9-3.6 percent from 2.9-3.7 percent.
    In the first quarter of this year, the U.S. GDP expanded by a quarterly 2.4 percent for annual growth of 1.8 percent, up from 1.7 percent in the fourth quarter of last year.

    In testimony to the a U.S. congressional committee on May 22, Federal Reserve Chairman Ben Bernanke said the central bank could "in the next few meetings take a step back in our pace of purchases," igniting speculation about a tightening of U.S. monetary policy and triggering an outflow of capital from emerging markets that had benefitted from the low cost of U.S. funds and the injection of fresh funds through quantitative easing.

    But the Federal Reserve stuck to its previous script, saying it would continue with its monthly purchases of $40 billion worth of mortgage-backed securities and $45 billion of longer-term Treasuries "until the outlook for the labor market has improved substantially in the context of price stability."

    The purchases of Treasuries and mortgage-backed debt aims to maintain downward pressure on long-term interest rates and support the housing market, helping stimulate economic activity.

    Following Bernanke's testimony, interest rates in the United States and most emerging markets have moved higher as investors anticipated a reduction in U.S. purchases of Treasury bonds.

    The FOMC also repeated that it was ready to increase or decrease the pace of its bond and security purchases as the outlook for inflation or the labor market changes.

    "While participants continue to think that, in the long run, the Federal Reserve’s portfolio should consist predominantly of Treasury securities, a strong majority now expects that the Committee will not sell agency mortgage- backed securities (MBS) during the process of normalizing monetary policy, although in the longer run limited sales could be used to reduce or eliminate residual MBS holdings," Bernanke told journalists.

About The AuthorCentral Bank News is dedicated to provide timely, and comprehensive global central banks news and policy developments (EconMatters author archive here.)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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