Don't expect the Fed to slow its tapering

The Federal Reserve has instituted several rounds of large-scale asset purchases, also known as quantitative easing (QE), in an attempt to stimulate the U.S. economy and promote a faster recovery from the Great Recession. The latest round, QE3, began in September of 2012.

Initially, the Fed committed to purchasing $40 billion of agency mortgage-backed securities per month until the labor market improved "substantially." Then it expanded the program that December by adding $45 billion per month worth of longer-term Treasury securities to the $40 billion worth of mortgage bonds per month.

In December of 2013, the Fed believed the economy had recovered to the point where QE3 could be reduced, and it began "tapering" its asset purchases by $5 billion in each of the two asset classes, i.e. to $35 billion worth of mortgage bonds per month and $40 billion worth of Treasurys. The purchases were reduced similarly in January, March and April of this year, and they now stand at $20 billion worth of mortgage bonds and $25 billion worth of Treasurys securities per month.

Each time the Fed has tapered, it has stressed that the "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."

But how willing is the Fed to alter its asset purchases in response to changing economic conditions -- such as the news last week that GDP growth was negative in the first quarter? My view is that the Fed will continue to reduce purchases in "measured steps" as it has so far, and only a big swing in the data about inflation, output and employment could induce the Fed to alter the course it's on.

In addition, I believe the Fed's willingness to alter its present course is asymmetric. It will be far more willing to increase the speed of the taper and end QE3 sooner in response to good news than it will be to reverse course in response to bad news. And if bad news does occur, it's likely to simply put the reductions on hold rather than undo the tapering it has already done by increasing the scale of asset purchases.

If the news is really bad, there's a chance it could reverse course, but for the most part the Fed is likely to look at any negative news as temporary fluctuations in the data.

However, the other element of the Fed's current policy, its abnormally low target interest rate, is likely to be more responsive to economic conditions.

The central bank has been vague about when, precisely, it intends to raise its target rate, saying only that "it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored. ... The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run."

The date when this finally occurs is likely to be much more responsive to economic conditions than the pace of tapering. That's mainly because the Fed views interest rate changes as having a more powerful effect on the economy than the tapering of asset purchases. Therefore, it needs to be more careful about adjusting the timing of rate hikes in response to changing economic conditions.