The Fed had no idea if the taper would terrify markets

January 8

The Fed minutes are here! (AFP photo/Karen Bleier)

Three weeks ago, the Federal Reserve announced it would begin slowing its bond-buying, beginning the long process of tapering its program of quantitative easing. Now we know more about how the internal debate over the taper caper played out, after the release of minutes of the Federal Open Market Committee’s meeting. Here are five points that stand out from the document.

They weren't really sure how the taper would work.

The minutes confirm what Chairman Ben Bernanke said in his press conference: The decision to taper wasn't a close call. "Most members" of the FOMC agreed that December was the right time to start, according to the documents. But that doesn't mean they were confident it would go off without a hitch. The minutes show they have varying degrees of confidence in their economic forecasts. Some also worried that markets would panic again once the Fed actually scaled back the program, as they did in June when Bernanke first signaled that tapering of bond purchases was imminent.

"As a consequence, many members judged that the Committee should proceed cautiously in taking its first action ... and indicate that further reductions would be undertaken in measured steps," the minutes say.

Call it the Test Taper, a full-dress rehearsal with a trap door that allowed them to change plans if things went awry — that is, if interest rates spiked dramatically after the announcement. Lucky for them, the audience loved the performance, and stocks ended the year at record highs while bond yields remained tame.

Fed officials are really worried that QE is putting financial stability at risk.

Fed staff surveyed members of the Federal Open Market Committee before the meeting to assess their views of the efficacy and risks around the Fed’s bond-buying program—which was intervening in the markets to the tune of $85 billion until this month. The most significant concern wasn’t about inflation (that would be very 2009). Rather, they “were most concerned about . . . risks to financial stability,” pointing out that easy money “could provide an incentive for excessive risk-taking in the financial sector.”

QE may be riskier then low-interest-rate policies.

They further saw the QE programs as more likely to drive these risks than the Fed’s usual tool of keeping short-term interest rates low, because the bond purchases work through lowering “term premiums,” or the extra compensation investors demand for buying longer-term bonds. Said the minutes: “The risks to financial stability could be somewhat larger in the case of asset purchases than in the case of interest rate policy because purchases work in part by affecting term premiums and policymakers have less experience with term premium effects than with more conventional interest rate policy.”

But bond-buying probably helps persuade markets the Fed is serious about keeping rates low.

A majority of Fed officials “judged that the marginal efficacy of purchases was likely declining as purchases continue,” but that doesn’t mean they don’t do some good. In particular, a number pointed to “the importance of purchases in serving to enhance the credibility of the Committee’s forward guidance about the target federal funds rate.” Translation: Talk is cheap. But when the Fed both says it will keep rates low for a long time to come and backs it up with bond-buying to show its commitment to easy money the promise on rates has more credibility.

Some want to make 6 percent the new unemployment threshold.

Fed officials debated lowering the unemployment rate at which the central bank will begin considering interest rate increases from 6.5 percent, where it has been since December 2012, to 6 percent -- the most specific alternative that has been mentioned in the official minutes so far. Though the idea was rejected in favor of the more generic promise to keep rates low "well past" the current threshold, expect Fed officials to revisit this idea, especially if the jobless rate keeps falling largely because of a shrinking labor force rather than robust job creation. Another point to remember: Minneapolis Fed President Narayana Kocherlakota will be joining the FOMC this year, and he has been one of the most vocal advocates of lowering the unemployment threshold.

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