Divyang Shah, Senior IFR Strategist
When it comes to the monetary policy outlook there are three distinct phases of tapering, pause and then tightening.
What the lags are between the three phases remains an unknown with the Fed focused on ensuring that there is a smooth transition from one phase to the next.
At the FOMC meeting next week we are told that the Bernanke will “press the point” that there will be a considerable amount of time between ending QE and higher short-term rates. Early this year we highlighted the potential risk of a snowballing of expectations that the Fed will embark on a removal of accommodation.
Note that the message here is not related to tapering of QE which the Fed seems to believe is necessary. At the very basic level the Fed is saying that there is a distinction between taking the foot off the accelerator (tapering) and when it will need to tap on the brakes (declining balance sheet and higher rates).
But it’s not going to be easy to divorce the three phases of tapering, pause and tightening for the market especially as the unemployment rate continues to trend lower.
If inflation is less of an issue and the Fed tapers QE this year then given that on the current trajectory the unemployment rate will have to be below 6.5% at end-Q3/early-Q4 of 2014 a rate hike seems obvious.
Forward looking markets do not sit idly by and will have to price in the risks that rates need to move higher even if this does not fit with what the Fed wants.
There remains a communication challenge for the Fed and Bernanke’s post-meeting press conference is very important for risk markets.
