There weren’t many surprises in the minutes, and they certainly didn’t change anyone’s outlook for Fed policy going forward.
Regarding the economy, the Fed remained cautiously optimistic. Apparently, though, the lack of a housing rebound is catching some Fed officials’ attention, so housing remains a key area to watch (reports coming out today and tomorrow are important). But, overall there appears large agreement that the economy was rebounding from a weather-induced slowdown in Q1.
The other focus of the meeting was on the Fed’s exit strategy from QE. I think that reflects two things: First, it’s going to take a big negative shock to the economy to derail tapering of QE, and the outlook for Fed policy (end of QE in October/December, first rate increases mid-2015) is about as set in stone as the Fed outlook can be.
Second, with the Fed policy outlook relatively “known,” the market’s focus is going to shift more to the specifics of the Fed’s “Exit Strategy” from QE. And, yesterday’s minutes implied that the Fed doesn’t really know how it’s going to “normalize” policy and its balance sheet (i.e., raise rates while they own so many Treasuries).
I suppose every plan begins with a conversation, and it seems that the FOMC has started the conversation about normalizing policy – now they just need to come up with a plan. Assuming the economy stays level through the coming months, Fed exit policy is going to become a more-important topic for the markets.
Know Where the (Fed) Exits Are
Current (and about to be ex) Fed Vice Chair William Dudley made some comments Tuesday about the Fed exit strategy that were generally viewed as “dovish.” But, that interpretation is incorrect, and Dudley’s comments may be one reason we saw some bond weakness Tuesday and Wednesday.
The media focused on the fact that Dudley said the “equilibrium” interest rate (a rate that isn’t accommodative or too tight) might be lower going forward than it had been in the past (so say well below 4%). There are many reasons for that but basically his main thesis is that the economy simply doesn’t have the growth potential it used to (due to demographics and other things).
That is a “dovish” statement, but it’s not something new.
Instead, the important part of Dudley’s speech had to do with the Fed exit strategy. Dudley said he believes the Fed should continue to reinvest principal payments from its QE purchases into other bonds, even after it begins to raise rates (presumably this will soften the blow). If that opinion reflects the consensus of the FOMC (and Dudley usually does) then that’s a change, as the Fed previously stated it would halt re-investment of QE purchases prior to raising rates.
Now, before your eyes glaze over, this is important because this change in policy may put more upward pressure on rates.
Here’s why: If the Fed stopped re-investing principal payments, that would remove artificial demand from the bond market, and bonds would decline/interest rates would rise faster than if the Fed was reinvesting. So, not reinvesting principal is a mild form of tightening.
If the Fed is going to continue to reinvest, though, then any tightening of policy the Fed wants to achieve will have to come solely from interest rate increases, because the rate increases will have to counter the re-investment of principal payments.
Again, I know this is pretty boring stuff, but understanding Fed policy is key, especially with regard to the expected direction of rates.