How Fed tapering could impact interest rates

After introducing the idea in May and changing its mind in September, the Federal Reserve finally decided to taper back its monthly bond buying program from $85 billion per month to $75 billion.

Among reasons for the this, the Fed cited moderate economic growth, improved labor conditions (though unemployment remains elevated), greater household and business spending, and inflation below a long-term target of 2% that looks to be sustainable.

10-year Treasury note yield

^TNX Chart

^TNX data by YCharts

Looking forward, the Fed stated the following:

If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. However, asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.

The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2%, especially if projected inflation continues to run below the Committee’s 2% longer-run goal. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 %.

This second paragraph includes a very interesting change that the Fed will no longer use a 6.5% unemployment rate as a target time for raising the Fed Funds Rate (short-term rates in general). This change probably recognizes a high number of people that have left the labor force and distort the true nature of the reported unemployment rate.  The statement also implies that it could be a while before they raise short-term rates as long as unemployment remains elevated and inflation runs at or below 2%.

For stock investors, this language appears to have outweighed the modest and generally unexpected cut in bond buying that led to today’s positive move in the equity markets.  Long-term interest rates did not change much and appear to be comfortable with moderate bond buying cuts that could come with Federal Reserve meetings in January and March.  Despite the lack of significant movement in long-term rates, I believe investors should still expect the 10-year Treasury rate to push above 3% sometime in the near future in an outlook consistent with the Fed’s modestly positive economic outlook and further tapering.