FOMC Expectations Show The Non-Taper Worked

The FOMC will release its October statement at 2PM today and the widely held expectation is that the Fed will stand pat and continue its $85 billion in bond purchases. Despite the overwhelming belief that the Fed would taper in its September meeting (it didn’t), the exact opposite belief is now conventional wisdom this time around. Why did everyone’s expectations about Fed policy take such a dramatic turn?

Not because the economy suddenly crashed. Equities are still rising and interest rates have fallen in the past month as the market has pushed back the timeline for the taper. The jobs report was underwhelming, but not catastrophic. Consumer confidence fell, though this wasn’t surprising. The government shutdown hurt the economy, but much of it will be made back in the upcoming quarters and we also avoided a default. The shutdown has also delayed the release of some economic data.

All in all, it has been a mediocre, slightly below average last month of economic news. But based on market expectations last time, slightly below average data would still lead the market to expect the Fed to taper. Since that’s not the case, then it’s not the data alone that has caused Fed watchers to adamantly believe that the Fed won’t taper this time. It’s because the Fed regained its credibility and realigned the market’s expectations with future Fed policy.

The Fed cannot commit to any action it will take in the future since it does not know the future state of the economy. But it can give the market a baseline of how it will react if certain economic conditions come to pass. That’s what Bernanke set out to do in June when he said that the Fed would begin tapering in the fall if the market continued to improve at a moderate pace. Over the summer, that improvement slowed, but the market didn’t adjust its expectations to take into account this slowdown. It assumed that the baseline that Bernanke laid out was a set path of action, despite his repeated admonitions not to take it that way.

In fact, this blind belief that the Fed would taper caused interest rates to rise which weakened the economy and gave further incentives to the committee to continue its bond buying. By pricing in the taper, the market helped create the economic conditions for the Fed to do just the opposite.

Through all of that, the FOMC sent a message in September: Don’t assume that the Fed won’t adjust its policy based on the underlying economic data. Finally, Fed watchers and the market are catching on. The 180-degree turn in expectations is a direct result of the Fed convincing the market that it’s data-dependent and for them to use the Fed’s forward guidance as just that, a guide not a set path. The unanimous belief that the Fed will not taper today is evidence of that policy’s success.


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