The Fed’s Tapering Catch-22

So much for tapering talk. The Fed surprised the markets by continuing its program of $85 billion per month of purchases of US Treasuries and mortgage-backed securities.  But the lack of tapering represents a missed opportunity to begin what will eventually be required. Tightening financial market conditions –the rise in interest rates following the Fed’s May-June comments on tapering –appear to be the reason for yesterday’s surprising decision to defer the moderation of purchases.

Clearly the Fed signaled the concerns it has with higher mortgage and interest rates – parts of the tightening in financial market conditions. The Fed understands that the economic recovery is relying on interest rate-sensitive segments of the economy and is being held back by the narrowness of job and income growth. Financial market conditions – rising housing and stock markets – provide the main source of support for the recovery in the form of supporting a wealth-induced incentive for spending. That spending comes about as consumers are saving less – not through rising incomes. And that leaves the economy too vulnerable to financial market conditions a point central to our year end rate expectations and underscored by the Fed’s actions Wednesday.

What should investors expect? Now that the Fed has pushed expectations for low rates out yet again, the performance of equities should do well in such an environment, but their long-run results will be challenged – much as they were in May and June – if and when the Fed decides it is time to try another go at exiting its program.

Source:  Jeffrey Rosenberg, Managing Director, BlackRock Chief Investment Strategist for Fixed Income

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