They Say Actions Speak Louder Than Words

But that doesn’t appear to be the case when it comes to Federal Reserve monetary policy. For some time, the Fed has been communicating its intention to gradually cut back its bond purchasing program (a.k.a. quantitative easing) while keeping the target fed funds rate steady. The target fed funds rate is the interest rate at which banks borrow money from each other overnight. The Fed has not taken action yet, but its words have caused nominal bond yields to rise and inflation expectations to fall. Typically, these changes are associated with tightening monetary policy. 

The Fed’s words also triggered significant market volatility. An article in The Economist suggested: 

“Fed officials are doubtless annoyed by the market’s skittish reaction to the idea of tapering. In its view a more leisurely pace of buying does not amount to tightening. Fed economists reckon the size of the central bank’s balance-sheet is what matters most: so long as its asset pile is growing, policy is getting looser. By the Fed’s estimates, halving the monthly rate of asset purchases would be equivalent to trimming the federal-funds rate by five basis points per month instead of ten.” 

The gap between the Fed’s perceptions and the markets’ response has been significant, and investors and analysts are scrambling to interpret the economic tea leaves. Researchers at Barclays Capital, whose work was cited in The Economist, have tried to determine how tapering may affect investment assets. Since stock markets in emerging countries and high-yield bond markets in the United States and Europe responded the most to the Fed’s quantitative easing program, experts anticipate these markets also may respond the most strongly when tapering begins.

 
 
 

Lexington Wealth Management