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April 25, 2013

Alan Levenson Alan Levenson, T. Rowe Price Chief Economist

With recent data showing the U.S. economy continuing to expand at a moderate pace, domestic stock markets trading near record highs, and some Fed officials publicly worrying that low interest rates could destabilize markets, many investors are increasingly attuned to signs that the central bank is preparing to temper its easy-money policies.

Change will come first to the Fed's asset purchase plan

Since late 2008, the Federal Reserve has kept the federal funds target rate in a 0.00% to 0.25% range, which has kept short-term market interest rates (such as money market rates) near zero. Last year, the Fed stated it will keep short-term rates at current levels at least until the jobless rate reaches 6.5%, provided that its intermediate-term inflation forecast stays below 2.5%.

In addition to its short-term interest rate policy, the central bank has implemented several asset purchase programs to suppress longer-term interest rates.

  • The Fed began purchasing long-term securities soon after the financial crisis to provide liquidity to stressed markets and to drive down interest rates—a less common monetary strategy known as "quantitative easing."
  • The Fed is currently buying a total of $85 billion in securities each month. Roughly half of these purchases ($40 billion) are directed toward agency mortgage-backed securities (MBS) under a plan that was announced and started last September.
  • The other half of these purchases ($45 billion) is directed toward Treasury securities under a plan that was announced in December. The course of the overall asset purchase program is tied to improvement in the labor market outlook.
The improving economy has changed expectations for monetary policy

The official jobless rate has steadily declined from its 10% peak in October 2009 to 7.6% in March—its lowest level since December 2008. The improving employment picture has raised speculation regarding how and when the Fed will wind down its asset purchase plan—an event that might see long-term interest rates rise.

After the Fed's latest policy meeting in March, Chairman Ben Bernanke explained that while the Fed will keep up its asset purchases until the job market outlook has substantially improved, it will reduce the pace of its buying in response to incremental progress toward its goal.

  • The Fed's March policy statement clarified that "in determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives" (new guidance in italics).
  • In effect, the Fed stated it would gradually adjust its monthly asset purchases based on changes in its job market outlook before it stops buying entirely.
What is the Fed waiting for?

Despite the incremental improvement in the labor market, we do not believe the Fed will ratchet down the pace of its bond purchases within the next couple of months. Rather, Bernanke has conveyed the Fed's intention to wait for confirmation that the recent pick-up in the economy will be sustained.

  • Although the Fed is seeing evidence that the economy is recovering, it wants several more months of evidence to make sure that seasonal factors are not behind the recent pick-up in payroll data. Payroll gains softened considerably during the middle of each of the last two years.
  • Policymakers also want more time to assess the impacts of tighter fiscal policies in the form of federal tax hikes that took effect at the start of 2013 and budget cuts due to the sequester that began in March.
We expect the Fed to begin paring the pace of asset purchases during the third quarter of this year

We share the Fed's concerns about the sequestration and possible seasonal quirks boosting recent payroll data. However, we expect that a stronger private sector will limit the impact of this year's fiscal tightening and keep forward momentum in the broader economy intact.

  • Despite the pullback in employment growth in March (only 88,000 jobs added), we believe a steady underlying growth trend remains in place.
  • Even with the impact of fiscal tightening, we expect that the economy will continue to grow at a roughly 2% pace over the coming year. As a result, monthly job growth will stay near 150,000 through into the second half of this year, encouraging the Fed to begin tapering the pace of asset purchases during the summer.
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