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Why did the Fed delay tapering of bond purchases?

News Analysis

(MoneyWatch) Despite widespread expectations that theFederal Reserve would begin reducing the stimulus it provides the economy through quantitative easing, the central bank said today that it will maintain its current pace of Treasury and mortgage bond purchases.

Four possible reasons explain why the Fed decided to delay tapering the $85 billion-a-month program.

Fiscal policy. Uncertainty over a possible government shutdown later this year, conflict in Congress over the federal debt ceiling, and the possibility of additional government spending cuts and other austerity measures seems to be making the Fed nervous about doing anything that might add to the negative shock from fiscal policy. Fiscal policy makers have performed terribly over the course of the financial crisis, and the Fed is the only game in town. It can't take the risk of adding to the potential problems that fiscal policy might cause.

Inflation and unemployment. Inflation is too low and unemployment is too high. There are no signs of an acceleration in the labor market, and no signs that inflation expectations are moving above the Fed's long-run target. As a result, why do anything that might be construed as a negative shock?

The Fed is gun-shy. When the Fed first began talking about scaling back its bond purchases, it was surprised by the ensuing rise in long-term interest rates, corresponding slowdown in housing and stock market plunge. Just talking about tapering led to an unexpected spike in interest rates, and although it appears that tapering was priced into financial markets, why risk another surprise? Additional bond purchases are unlikely to do much good for the economy -- all that can be done has pretty much been done already. But there is potential for a negative reaction from markets, and with the lackluster recovery, fiscal policy worries and other economic concerns, why take a chance?

Capital flight from developing markets. As investors have anticipated rising yields due to the Fed potentially beginning to taper, capital has flowed from developing markets to the U.S. That has caused economic problems that could feed back into U.S. markets, making a slow recovery even slower.

Overall, while there isn't a lot to be gained from the Fed continuing the bond purchases. But there is potentially a lot to lose from miscalculating the markets' reaction to the onset of tapering. As the Fed said today in its policy statement explaining its decision to keep the program intact, "the committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases."

So if the economic data look good between now and the Fed's next meeting in December, particularly job growth, we can expect the Fed to begin reducing the volume of asset purchases, perhaps by $5 billion to $20 billion a month. But if the numbers still look weak, a delay in tapering until January -- the central bank's last meeting before Chairman Ben Bernanke hands the reins over to a new Fed chair -- or even beyond is not out of the question.