Markets are now expecting the Fed to end QE on schedule, in spite of recent market volatility and faltering foreign economies. I don’t see much reason to dispute that. The Fed wants to be rid of the QE straitjacket, even if it was a good fit last year. It’s better to be less constrained.
There have been some rough, scary days in the bond market recently, to be sure. But the Fed tends to have a “markets go up, markets go down” weary disdain for short-term volatility, at least so long as the mechanics of markets like clearing and settlement are working fine. Less liquidity in junk bonds is not enough to break the US economy, even if it might break some leveraged players with positions the wrong way round.
The central bank also tends to act with a lagged response compared to market players: officials tend to look at the broad average of data since the last meeting, rather than market mood-swings on the latest few days of data.
It would need much larger and more persistent market disruption to alter the Fed’s course. Indeed, you have to expect and even welcome some market upset as the Fed gradually returns to normality. A few market headaches now might reduce market complacency and tendency to bubble behavior. A little bit of two-way risk on Wall St is no bad thing.
That is not to deny the global real economy outlook is getting darker. Weakness in foreign economies is something which needs further monitoring, but the US has plenty of experience with being left as the demand locomotive which is supposed to pull the rest of the world along with it. Just about every US economic official of the postwar period has tried to persuade the Europeans to stoke demand a little more, for example. The Fed will probably want to see firm evidence of foreign weakness actually affecting the US, and is also conscious that falling oil prices will boost the US consumer. A rising US dollar will also boost foreign economies.
So the message will be a perennial Fed line: we will judge the pace of tightening in the light of incoming data, we have no precommitments to any course of action but will respond flexibly to new information.
The market can take the same message in different ways, though , and that’s where the main uncertainty lies. Investors may read that message as a willingness to delay rate rises next year, but there won’t be anything substantially new in it. But of the Fed chooses to reemphasize it has many tools to deal with contingent weakness despite the end of QE3, that might sound dovish to some ears. It’s all the same thing, however.
Could the Fed surprise with an extension of QE? The only reason would be to shock the markets with an additional injection of dovish credibility. But that runs into a “save the ammunition” argument: if there is any chance you may need to respond to a major negative shock later, it makes more sense to keep your powered dry until you can see such a target. So I think it is not the time to spring a major surprise.
Remember that Yellen is not a perpetual dove. It’s just that as long as domestic inflation seems muted or non-existent, she’ll err towards keeping rates low for longer. Look for a revival of the “first rate hike” versus “steepness of rate trajectory” debate before long, though. The longer you leave the first hike, the steeper subsequent rate hikes might have to be – and that could lead to bond market gyrations that make the last few weeks look like child’s play.