The Washington PostDemocracy Dies in Darkness

Markets used to freak out over tapering QE. The Fed has persuaded them not to.

(Karen Bleier/AFP)

If there is one sentence that encapsulates the communications message coming out of the Federal Reserve over the last few months, it is this: "Tapering is not tightening." That is to say, just because the central bank begins slowing the pace of bond purchases, that is not the same as raising interest rates or otherwise trying to tighten the money supply.

If they can pull off the trick of separating the two, it will make Ben Bernanke and soon Janet Yellen's job a lot easier. They could maintain low interest rate policies to stimulate the economy, while winding down their signature quantitative easing policies, which are creating some unwelcome side effects.

But persuading markets of that is a different story. Through the summer, the increasing talk of winding down QE went hand in hand with investors anticipating that the Fed will start hiking short-term interest rates than they had previously thought. For example, here is how market perceptions of the odds of a Fed rate hike by December 2014 have evolved. (The data is drawn from the Bloomberg's calculations of the implied probabilities based on futures market prices).

As it shows, through the summer months the futures markets priced in a high likelihood -- at one point over 60 percent -- of rate hikes by the end of next year! This was true even though 15 of 19 Fed officials had indicated that they thought the appropriate timing of a rate hike wouldn't be until 2015 or 2016.

In effect, the markets were saying: "We don't believe you." The fact that the Fed was gearing up for tapering signaled to traders that they also were going to begin raising short-term rates sooner rather than their official communications had suggested was the plan. Markets were believing their actions, not their words.

But in the last couple of months, the Fed has finally had success at persuading markets that tapering bond purchases doesn't mean that interest rate hikes are near, the data suggest. Markets assign only about 9 percent odds of a rate hike by the end of 2014, which seems consistent with the message out of the Fed itself. The central bank would only hike rates in 2014 if the economy really took off, growing more rapidly than people expect over the coming year.

What happened during the summer was that expectations for bond buying became closely correlated with longer-term interest rates. When data came in or a Fed speech was delivered that suggested tighter money would be warranted sooner, simultaneously the long-term Treasury bond yield would rise (indicating investors expected less bond-buying from the Fed) and the odds of near-term rate hikes increased.

Here, for example, is the four-week rolling correlation between the one-day change in the 10-year Treasury bond yield and the futures market's expectation for the Fed's short-term interest rate target in December 2014. As it shows, in the four weeks preceding July 15, the correlation reached 92 percent! In other words, back during the summer, investors thought that there was almost a perfect relationship between the Fed's bond buying plans and its plans for short-term interest rates.

But now that correlation has come way, way down, to 45 percent for the four weeks ending Tuesday. It's not surprising that there is some positive correlation between these two numbers. After all, news that points in the direction of a stronger economy should point both to higher long-term interest rates and sooner rate hikes by the Fed. But the fact the two correlate much more weakly than they did over the summer is a sign that the Fed's communications offensive of trying to disentangle the two policy tools is having an effect.

Assuming the pattern continues, that's good news for the Fed, and for the economy. It suggests that the Fed could begin winding down its signature bond buying program without the kind of runup in interest rates that was evident back in June when it first signaled tapering was imminent.

That's a big deal. There are already hints that the summer spike in rates damaged the housing recovery, and it definitely brought unwelcome volatility to financial markets. Janet Yellen will have a considerably easier job as she takes the reins of the central bank if she can manage to keep cheap money in place even as the Fed pulls back from QE.

For more on the pivot the Fed is trying to undertake--from focusing less on bond buying and more on the future path of short-term interest rates, read "Ben Bernanke is trying to make Janet Yellen's job easier. Here's how."