The Federal Reserve Open Market Committee completed their final meeting of 2013 on Wednesday, and while some economists called for the closely-watched tapering decision to be put off until 2014, a $10 billion/month program was announced. No doubt, you are probably as tired of hearing about tapering as we are, so this provides a bit of closure to the question, although there is still a long road ahead. Probabilities for this happening had risen over the past week, although there were plenty of well-regarded economists who called for it to begin in January or March of next year.
Why the change? The economy continues to be growing at a ‘moderate’ pace, according to the committee. Since October, better labor numbers and improved capital expenditures added a few points to GDP, while flattened housing figures offset that somewhat. Also, inflation remains quite low and below the committee’s target.
The Fed might also have been weighing whether or not to lower the unemployment target from 6.5% down to 5.5-6.0%, which it did not end up doing. The minutes from the October meeting alluded to discussion about the topic. The second component of today’s news release was an acknowledgement by the committee that it could ‘likely be appropriate’ to keep rates at zero ‘well past the time’ that this target is hit—which came as somewhat of a surprise.
The Fed has dual mandates of maximum employment and price stability. Unemployment is still higher than desired (far below ‘maximum employment’) and inflation is not yet problematic as measured by their conventional metrics. Therefore, despite the tapering of the stimulus, there is still ample stimulus as they continue to operate on the side of accommodation as opposed to pulling off the gas too early and risking a sputtering of the engine.
At the same time, QE is a dramatic emergency measure, and one could argue whether this policy continues to be as appropriate several years after the depth of the financial crisis. Naturally, the longer this goes on and the more positive and sustainable the underlying economic data looks, the greater the counter-argument against stimulus.
We bring this back full-circle to what this means for us in an asset allocation context. Risk assets traded higher on the news, which reflects the stronger underlying economic conditions, while bond rates ticked upward.
- Fixed income: Continued stimulus and easy policy means lower bond yields for longer (although the rate ‘spring’ has been getting increasingly compressed and tapering only releases some of the tension). As economic growth improves, it is fair to expect higher rates. This could be quite damaging to conventional fixed income portfolios depending on how quickly rates rise.
- Equities: As economic growth continues, this translates to both improved company revenues/earnings as well as a positive feedback loop as consumers feel increasingly comfortable about forward-looking prospects. When this occurs they increase their own spending. It would not be surprising to see continued strength vs. fixed income while accepting the occasional bouts of volatility we expect from this asset class.