The 210 pages long transcript of the FOMC meeting held on 30 April-1 May 2013 mentions 95 times the words ‘taper’ or ‘tapering’. Despite the intense discussion, Fed Chairman Ben Bernanke was very cautious when, three weeks later, on 22 May 2013, he revealed during a congressional appearance that the Federal Reserve was thinking about slowing down the pace of its asset purchases. He simply stated “If we see continued improvement and we have confidence that that’s going to be sustained then we could in the next few meetings … take a step down in our pace of purchases.” Yet, this, at first glance anodyne statement, was surprising and what followed was a brutal market reaction, across the globe and in particular in emerging economies, lasting for several months. These events have gone down in history as the taper tantrum. They are a reminder of the difficulty which the Fed may experience when, in the context of its new longer-run strategy, it will contemplate its first policy tightening in the current cycle. This looks like the inevitable outcome of the new approach of targeting an inflation average, which means ‘low policy rates for longer’ in order to push inflation above the 2% hurdle for some time. This (quasi-)inevitability is caused by increased sensitivity of asset prices to policy tightening and by the ambiguity about the Fed’s policy reaction function going forward. Concerning the former point, in a first phase, which may last quite some time, the new strategy should underpin risk taking in financial markets leading to higher asset valuations –such as tighter corporate bond spreads versus treasuries or a higher price/earnings ratio in equities. After all, fluctuations in the required risk premium, across asset classes and continents, are closely tied to Federal Reserve policy. Much like the increase of the duration of a bond when yields decline, higher asset valuations will lead to an increased sensitivity and volatility when policy is tightened after all. This brings us to the second cause, the ambiguity about the Fed’s policy reaction function. Under traditional inflation targeting, markets gradually anticipate a policy tightening when inflation picks up and converges towards the target. In this respect, in recent years, forward guidance has taken on a prominent role in trying to bring market expectations under control.  Following the change to the Fed’s strategy, communication and guidance on future policy will become even more important because the future reaction of the central bank to inflation developments is not clear. Firstly, because the Fed is, quite understandably, not tying itself to a particular mathematical formula that defines the relevant inflation average. Secondly, it is not clear how much and for how long inflation will be allowed to move beyond 2%. The more and longer this lasts, the bigger the risk that investors would start to price in aggressive tightening, as if the central bank would need to play catch up. The abrupt change in market expectations can have significant market consequences as we have seen in 2013 during the taper tantrum. Interestingly, the Federal Reserve doesn’t seem to be very concerned about this risk. In a research paper on Monetary Policy Strategies and Tools: Financial Stability Considerations which was prepared for the Fed’s strategy review, the authors acknowledge that “All else being equal, low rates buoy asset prices” but consider that “the longer-run effect of low rates on financial vulnerabilities is uncertain”. It thus seems that the central bank, faced with, on the one hand, a high likelihood that its old strategy could cause a downward drift of inflation expectations and, on the other hand, the uncertainty about possible detrimental consequences of its new policy for financial stability, has put more weight on the former consideration. This is understandable, but it will make the normalization of monetary policy trickier, for the Fed and for market participants. It will also increase the importance of forward guidance.

Reproduced with the kind authorization of L’AGEFI