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Talk of ‘tapering’ (ie a reduction in the level of asset purchases) has been all the rage over the past month, helping to spark the volatility that has been the hallmark of recent trading sessions. The theory was that a general improvement in US data was showing the effectiveness of QE3 as a policy, and that the Fed would start to ease off on purchases to avoid initiating a surge in inflation. Minutes from the April meeting showed that some members of the FOMC (the policymaking body) were getting anxious about inflation and thought that a reduction in purchases might be warranted at the next meeting.
The possibility of a change in policy at the June meeting comes much earlier than investors had expected, as they have, it is fair to say, grown used to the idea of an interventionist Federal Reserve. QE is not designed to ‘prop up’ stock markets per se, but it has had this effect. Investors have returned to stock markets in the confident belief that the Fed is acting to counter any resurgent weakness in the US economy.
Yet, as we wait for this month’s meeting, I don’t expect a change in policy. What we are likely to get is a potential ‘ratcheting up’ of the hawkish tone. By this, I mean that the statement will show a higher awareness of the dangers of inflation, although US CPI (with the next reading due on Tuesday) is still not approaching the 2.5% year-on-year growth laid down as a principle by the ‘Evans Rule’.
The Fed is acutely sensitive to accusations that it is stoking a bubble in equity markets, but it can in honesty say that rising stock market prices were never a primary goal. They are merely a by-product. In fact, US economic data has still to show the real, sustained and significant improvement that would suggest that the world’s largest economy is capable of surviving on its own without assistance.
Tapering, and the communication thereof, will be a tricky task for the Fed, when the time comes, but we are not there yet. As ever, watch what the Fed does and worry less about what it says. Hawkish statements and minutes have been the form for a while now, as the Fed looks to avoid spooking the bond markets. However, we should not pronounce the end of QE3 (or even the beginning of the end), unless and until it starts cutting back on the $85 billion a month in asset purchases.