The Federal Open Market Committee's announcement Wednesday to reduce the Federal Reserve's monthly purchases of Mortgage Backed Securities and Treasuries of $85 billion a month to $75 billion a month came as a surprise to many market participants.


Global equity markets were completely hammered in the summer of 2013 after Ben Bernanke, chairman of the Fed, first signalled 'tapering' in light of better than expected economic data. However, continued upside momentum, especially in housing data and jobless claims in the US; improving economic conditions in the Euro-zone and the United Kingdom; and a pullback in global commodity prices led to a six-month rally in global stock indices to multi-year highs.

Further, the end to Quantitative Easing (QE) was inevitable -- it was only a question of when and by what amount. For bond and currency traders, it was all a matter of positioning and correctly timing their short bonds and long dollar trades. At some point, the market had to price in this withdrawal of easy liquidity and valuations had to be justified in a post-Quantitative Easing regime.

But does this initial taper signal the end of the unconventional monetary policy era as we know it? Will the Fed taper at the same rate going forward or will it increase its reduction in the monthly purchases of MBSs and Treasuries going forward so as to completely wind up its QE programme by the end of 2014?

Monetary policy is all about managing future expectations and delivering forward guidance to the market. Thus, it is crucial to pay attention to the change in the language and tone of the latest FOMC statement.

Over the past year, the Fed has directly linked its monetary policy stance to two macroeconomic variables -- inflation and unemployment. In December 2012, the FOMC committed to keeping the Federal Funds rate between 0-0.25 percent as long as: the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's two percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

But in the FOMC minutes released Wednesday, the Committee now anticipates, based on its assessment of the labour market outlook and price stability amongst other 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 percent, especially if projected inflation continues to run below the Committee's two percent longer-run goal."

Both the statements imply that even if QE were to end, the Federal Funds rate will remain near or at the zero-bound. Thus, what has now commonly come to be known as the Zero Interest Rate Policy (ZIRP) environment will continue to exist if certain thresholds for employment and inflation are not met.

What the slight change in the language of the FOMC implies is that any setback in the improvement in the labour market and a failure of an uptick move in inflation can put a brake on tapering. On the employment front, it is important to note that the US faces a structural rather than a cyclical problem.

The labour force participation rate has now fallen to the lowest level since 1978 with the number of unemployed Americans leaving the workforce exceeding those entering it for the 43rd consecutive month, according to the Bureau of Labour Statistics.

Further, as per an analysis by Christopher Wood of CLSA, the Fed's favourite inflation indicator, the core PCE deflator, declined to 1.1 percent Year-on-Year, well below the central bank's two percent objective.

Going forward, the extent of tapering will solely be a function of inflation and unemployment data. What is clear now is that the market can sustain its current levels and even rally on the back of Fed tightening. Risks on moves are being driven by strength in the real economy, and not by cheap liquidity.