The Fed’s Strategy

At its December meeting the Federal Reserve has decided to reduce its asset purchases. It used to be USD 85bn since September 2012; it will be USD 75bn from next January. MBS and TBonds purchases will be reduced both by USD 5bn.
Guidance on interest rates is unchanged. The Fed will start thinking at a change in its interest rates when the unemployment rate will be at 6.5% (7% in November 2013) and when inflation expectations will be at 2.5% at 1 to 2 year horizon (0.5% above the Fed target which is at 2%)

The rationale behind this decision is threefold
1 – The Fed has no pre-commitment on its asset purchases. There is neither calendar nor threshold at which they will stop buying assets. In June asset purchases were supposed to be stopped as soon as the unemployment rate reached 7%.
The Fed just said that the reduction in purchases will continue if the economic conditions are favorable.
That’s an important difference as the Fed has not tied its hands.
2 – The Fed considers that the economic situation is robust now. It doesn’t say that growth will pick up rapidly but just that the risk on economic activity is now balanced. It’s an easier situation to manage than in June where there were still some downside risks (mentioned in the press release).
3 – Inflation rate is low and will remain low or a long time period. In the Fed’s forecasts 2% in the upper level for the inflation rate in 2015 and 2016.

These three conditions together
The Fed will begin to consider raising its interest rates when the unemployment rate will be 6.5 % and when expectations on 1 to 2 year inflation rate will be at 2.5%. As there is a cap at 2% in their forecasts the Fed is expected to keep its interest rates stable until 2016.

The reaffirmation of the path of inflation is the important factor in about the Fed. It’s what will allow its low interest rates strategy.
If the economy follows a more robust profile with limited downside risk then the Fed may implement additional purchases of financial assets. This will allow it to stop buying financial assets in the second half of the year.
In other words, strengthening of economic activity is the support of the Fed to reduce its purchases of assets and an inflation rate permanently below its 2% target will help the Fed to maintain its very low interest rates.

The difference with June’s statement is that there are no pre-commitments on a  reduction profile of asset purchases. The other difference is on the risk profile for the economic activity. There were downside risks in June, they are balanced in December.
As in June, the reaffirmation of a very low inflation rate is key to ensure very low interest rates for long.
As Bernanke mentioned it at the press conference, the Fed main instrument is the interest rate and the target is to maintain them at a low level. Bernanke mentioned the asset purchases as a secondary instrument and its termination will not be a strong issue for the Fed (the management of the entire asset purchased is another issue)

The question is how investors will react to this configuration? Will they accept the scenario of the Fed without saying anything or will they quickly begin to anticipate higher interest rates as growth recovery is on its way?
If this is the case, if there is too much pressure on interest rates, the Fed could be more proactive than what is currently defined in terms of unemployment rate. But this would reduce its credibility.
The confrontation between the expectations of a more robust economy and the desire to maintain low interest rate will be the challenge of the first month of Janet Yellen to avoid a too rapid flattening of the yield curve, may be even before 2016.

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