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PIMCO: The Three Messages Ben Bernanke Has Sent to Placate Investors

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These important takeaways have shelf life and will likely remain in force, influencing the bond market for quite some time.

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1. Tapering is not tightening.

It is widely believed that a reduction in asset purchases will occur this coming September or perhaps a bit later, but Bernanke reiterated the analogy that the Fed will merely be letting up on the accelerator rather than braking. The current consensus is for a reduction from $85 billion per month to $60 billion–$65 billion in September.

To provide some perspective, the experts at PIMCO's mortgage-backed securities (MBS) desk have pointed out that the expected $10 billion reduction in Agency MBS purchases – the other $10 billion–$15 billion will be from Treasuries – will be less than the reduction in MBS origination occurring as a result of the recent plunge in mortgage refinancing activity tied to the increase in mortgage rates. The net effect is that we expect the Fed will be purchasing, on a percentage basis, more Agency MBS than it did when the program began. Moreover, the Treasury Department is indicating that for the first time in three years it will soon reduce its issuance of Treasury notes, owing to this year's sharp decline in the U.S. budget deficit. So, any cutback in Fed buying of Treasuries will be partly offset by a cutback in Treasury issuance.

Keep in mind also that even when the Fed cuts back on its buying it will still be holding trillions of dollars of securities, thereby reducing the amount of bonds that private investors can buy. Natural buyers, which include the central bank reserve managers, pension funds, insurance companies and banks, therefore will likely bid higher than otherwise for the MBS and Treasury securities that remain on the shelves. The Fed's bond buying in itself is powerful, but there's something more important …

2. The policy rate, the policy rate, the policy rate!

Bernanke also made clear the distinction between its asset purchase program (aka QE3) and the federal funds rate. These are two separate tools that will not move in tandem. As the Fed has emphasized, there will be considerable time between the end of asset purchases and the first hike in the policy rate. PIMCO now expects the fed funds rate to remain unchanged until early 2016, given persistently low inflation and slow growth.

3. Data, rather than a date, will determine the Fed's next move.

When the asset purchases began in September 2012, unemployment was at 8.1%. Today, after nearly a full year of data and a 0.7-percentage-point drop in the unemployment rate, the Fed has only now become motivated to consider tapering. In other words, it takes cumulative data to make a case for the Fed to decide on a change in policy. Ultimately, it's the data, and not simply the passage of time, that will influence the Fed's decision-making.

These messages are resonating with investors, whose visions of the wild blue yonder are painted in green on the money the Fed will be printing for quite some time.

The Manager of the Pearly Gates

We can't know whether Ben Bernanke will leave the Fed for greener pastures when his term expires in January 2014, but if he does, whoever is chosen to guard the Fed's pearly gates will be bound by a greater power: rules and the strength of the institution. Here's what I mean:

1. The Fed operates under a congressionally charged dual mandate to promote price stability and employment. The next Fed chair (and the next and the next) will be dutifully bound by this mandate.

2. The ghosts of Bernanke, Greenspan, Volcker and the array of former FOMC participants and members who have served the Fed will be in the boardroom when the next Fed chair is sworn in. In other words, the next Fed chair will be expected to and almost certainly will aim to preserve the integrity of the Fed along with the hard-won gains it has earned over the past 30 years in upholding its dual mandate.

3. The Fed is currently operating under a rules-based approach to monetary policy, using forward guidance to communicate to markets the expected path for monetary policy. The Fed has said, for example, that QE3 will likely end when the unemployment rate is around 7.0%, and that the federal funds rate will be kept at 0%–0.25% at least until the unemployment rate reaches 6.5%. The next Fed chair will be bound by these rules. To be sure, the Fed may move the goal posts (change the thresholds), but likely only in a manner that is friendly to markets, because the inflation rate it uses to guide monetary policy is at a 50-year low. This gives the Fed room to be patient about slowing its pace of accommodation, as well as eventually withdrawing accommodation.

Therefore, the outlook for interest rates depends less on the selection of the next Fed chair than it does on the Fed's overall approach to the policy rate, and PIMCO believes the Fed will not increase that rate until 2016. The inflation rate is also vitally important to the outlook. Investors therefore are advised to remember most of all the importance of the policy rate, the inflation rate and the above factors if market volatility increases as a result of speculation about who will be chosen to lead the Fed and the throngs of people who follow the Fed.

This article by Tony Crescenzi originally appeared on PIMCO.
No positions in stocks mentioned.
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