Why the Fed’s policy took a key turn in its April–May meeting

Market Realist

A must-know investor's guide to the Fed's asset purchase tapering (Part 2 of 7)

(Continued from Part 1)

The first signs of a taper

The Fed first hinted at exit strategies for its monthly bond buying program in its Federal Open Market Committee meeting (FOMC) held from April 30 to May 1, 2013. At that point, the Fed was purchasing agency-backed securities and longer-term Treasuries at the rates of $40 billion per month and $45 billion per month, respectively. To understand the rationale for reviewing exit strategies for this program, we need to review the key variables that formed the basis of the Fed’s decision.

What was the Fed’s take on unemployment, inflation, and the federal funds rate?

In this meeting, the Fed defined its stance on accommodative monetary policy with respect to unemployment. To achieve the economy’s goal of full employment and maintain price stability, the Committee explained that it decided:

“To keep the target range for the federal funds rate at 0 to ¼ percent… at least as long as the unemployment rate remains above 61/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

The Fed also said that when “the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.”

What was the Fed’s stance on tapering and exit strategies?

At the end of this meeting, the FOMC members began a review of the exit strategy principles that were issued in order to clarify how the Fed intended to normalize its monetary policy stance when economic fundamentals dictated. These discussions included the size and composition of the System Open Market Account (SOMA) portfolio in the longer run, the use of a range of reserve draining tools, the approach to security sales, the eventual framework for policy implementation, and the relationship between the principles and the economic thresholds in the Committee’s forward guidance on the federal funds rate.

Impact on interest rates

The Fed’s goals in continuing to maintain its $85 billion-a-month bond buying program were to keep “downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.” Instead, rates increased. The market yield on U.S. Treasury securities at ten-year constant maturity rose from 1.7% on April 30, 2013, to 3.04% by year end 2013.

This was the first indication from the Fed that it was considering strategies for a return to “normalization” of its monetary policy—that is, to curtail its monthly asset purchases of $85 billion (at that point in time). A curtailment in the program (or tapering) would reduce the demand for longer-term Treasuries and agency-backed securities, lowering their prices and increasing yields. In reaction to the Fed’s hint at exit strategies, yields increased and bond prices fell.

To find out how markets reacted to Fed statements in upcoming meetings, move on to Part 3 of this series.

Continue to Part 3

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