Policy Matters

FOMC Preview

Western Asset

In advance of this week’s FOMC meetings, we offer our insight regarding the meetings’ economic backdrop, the likelihood and potential impact of tapering, and the Fed leadership transition, among other topics.

Economic Data

Since the September Federal Open Market Committee (FOMC) meeting, job growth hascontinued at a pace slightly below 200,000 jobs per month and the unemployment rate has declined to 7%. While the direction is positive, the recent data do not show any acceleration from previous months. Inflation continues to be well below the Federal Reserve’s (Fed) 2% target.

Tapering

There will be a lively debate about the timing of tapering, with strong positions taken by both sides. Our view is that the core of the committee (Fed Chairman Ben Bernanke, Fed Vice Chairman Janet Yellen, and President of the New York Federal Reserve William Dudley) will prefer to wait for a more convincing acceleration in the economic data, and thereforewillchoose not to taper at the December meeting. Instead, theywill likely plan to taper in either the January or March FOMC meeting, should the data continue apace. However, the Fed’s desire to “change the mix” of accommodation is a wildcard and could lead to a surprise tapering announcement this week.

Impact of Tapering

Even though there is uncertainty about the exact timing of tapering, markets generally expect that tapering is coming sometime in the next three meetings (December, January, or March). Therefore, the more important question is: how will the market react to tapering once it is announced? Our view is that the market reaction to the coming taper will likely be much less volatile than its reaction to “taper talk” this past summer. In addition to the fact that the market has now had many months to adjust to the idea of tapering, two considerations suggest the next round will be less volatile: Treasury yields are much closer to “fair value” than they were in May, and forward guidance appears to have done a better job of anchoring short-term interest rates than it did this past summer.

Enhanced Guidance

The FOMC is actively considering ways to enhance its forward guidance. A number of options are on the table, including lowering the unemployment rate threshold to 6%, setting an “inflation floor,” providing a clearer description of the pace of tightening following the initial hike, and lowering the interest paid on excess reserves. Our view is that setting an “inflation floor” is the most likely next step; lowering the unemployment rate threshold will most likely be reserved until later, should additional tools be needed in the second half of 2014.

Leadership Transition

At the moment it appears that Yellen will not be confirmed as Fed Chairman by the Senate prior to the December meeting, but she is likely to be confirmed by the January meeting. News reports over the past few days indicate that Stanley Fischer is likely to be nominated as Yellen’s Vice Chair. Fischer would bring a tremendous amount of expertise on financial stability and regulation to the FOMC. Our view is that the initial reports on his preferences for monetary policy are not especially relevant, given that his focus will likely be on financial stability and regulation and Yellen will remain the de facto leader of the FOMC on monetary policy.

Budget Deal

This week Senator Patty Murray and Congressman Paul Ryan announced a small budget deal. This was approved by the House of Representatives, and will likely be approved by the Senate. The deal would slightly increase government spending next year, offset by increases in fees and federal employee pension contributions. This deal would make a shutdown in January very unlikely, but would not address the debt limit, which needs to be raised by late March or early April. That said, we do not think another debt limit showdown is likely in March.

In the coming weeks, we will offer ourcontinuing analysis of the upcoming FOMC meeting and other WashingtonDC-related issues. Please continue to visit www.westernasset.com to access this commentary.

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