Fed finally finds elixir to sugar-coat stimulus cut

Fed finally finds elixir to sugar-coat stimulus cut

Reinforces its assurances that interest-rate increases are far off

By Caroline Salas Gage And ?steve Matthews (Bloomberg)

Published: Fri 20 Dec 2013, 11:33 PM

Last updated: Tue 7 Apr 2015, 4:49 PM

The news conference of Ben Bernanke appears on a television screen at a trading post on the floor of the New York Stock exchange on Wednesday. The Fed will trim its $85 billion a month in bond purchases by $10 billion starting from January. — AP

For six months, the Federal Reserve has struggled to engineer a pullback of its bond-buying programme without unhinging financial markets. On Wednesday, the Fed did it.

After the Fed and Chairman Ben S. Bernanke expressed enough confidence in the jobs outlook to taper the pace of asset buying and extended the timeline for zero interest rates, US stocks surged to record highs and 10-year Treasury yields rose just six basis points. That’s the opposite of Bernanke’s experience in June, when global equity markets lost $3 trillion in the five days after he said he might reduce his $85 billion in monthly bond purchases this year and end it by mid-2014.

Since then, policy makers have tried to convince investors that tapering quantitative easing isn’t tightening policy. They succeeded on Wednesday by coupling a $10 billion reduction in monthly asset buying with a stronger commitment to keep interest rates at record lows, according to Ward McCarthy, chief financial economist at Jefferies in New York.

“The Fed is trying to get policy back in the direction of normal without causing setbacks in the economy and too much distress in financial markets,” said McCarthy, a former Richmond Fed economist, who predicted the Fed would taper. “Based on the initial reaction, they found a magic elixir.”

The Standard & Poor’s 500 Index rose 1.7 per cent on Wednesday to 1,810.65 points, its biggest gain in two months. Yields on the benchmark 10-year Treasury note climbed 0.06 percentage point to 2.89 per cent, according to Bloomberg Bond Trader prices. That’s below the 2.99 per cent reached on September 5 on speculation the Fed would taper that month. In September, the Fed refrained from tapering in part because of the rise in borrowing costs.

Bernanke said on Wednesday his actions were “intended to keep the level of accommodation the same overall and to push the economy forward.”

For the past year, the policy-setting Federal Open Market Committee said that it would probably hold its benchmark rate near zero “at least as long as” unemployment exceeds 6.5 per cent, so long as the outlook for inflation is no higher than 2.5 per cent.

On Wednesday, the Fed reinforced its assurances that interest-rate increases are far off by saying its benchmark rate is likely to stay low “well past the time that the unemployment rate declines below 6.5 per cent, especially if projected inflation continues to run below” its two per cent target.

Inflation measured by the personal consumption expenditures price index rose 0.7 per cent for the 12-month period ended in October, and the jobless rate last month was seven per cent.

“It’s an important achievement” that markets are showing confidence in the Fed’s interest-rate outlook, said Columbia University economist Michael Woodford. He urged central banks to adopt “forward guidance” as a form of stimulus at a Kansas City Fed symposium in 2012 before the Fed established the unemployment and inflation thresholds.

“They have been trying for some time to get across the point that expectations about the path of asset purchases and about the path of interest rates should be two separate things, but earlier in the year, there seemed to be some confusion in the markets about that,” Woodford said. On Wednesday, the Fed “underlined the difference quite firmly and the market reaction suggests that this is now considered credible.”

Money-market derivative traders pushed back their expectations for the timing of the first increase in the target for the benchmark federal funds rate, which has been between zero and 0.25 per cent since December 2008.

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