Long wait for Fed tapering decision finally ends

LONDON Sun Sep 15, 2013 2:03pm EDT

LONDON (Reuters) - So great is the Federal Reserve's worldwide impact that exactly how the U.S. central bank frames its widely expected decision to start buying fewer bonds will be critical for the path of the global economy.

U.S. bond yields have surged since Fed Chairman Ben Bernanke said in May that the policy-setting Federal Open Market Committee could start tapering its asset purchases from $85 billion a month at the 'next few meetings.'

Despite assurances that the stimulus would be withdrawn gradually and that interest rates would not rise any time soon, investors have been pricing in a turning point in the financial cycle.

If yields shoot even higher after this week's Fed meeting, confidence will be rattled, the already feeble housing-driven U.S. recovery could stumble and investors in emerging economies might again start rushing for the exit.

What's more, U.S. monetary policy largely determines global capital flows. So rising U.S. borrowing costs would make it harder for the European Central Bank and the Bank of England to convince investors through forward guidance that they are being premature in bidding money market rates higher.

Claudio Borio, director of research at the Bank for International Settlements in Basel, said the increased sensitivity of markets to changes in the monetary policy outlook had prompted central banks to adjust the way they communicate.

"But there are limits to how far good communication can steer markets. Those limits have become all too apparent," he said.

While yields must rise eventually from levels that are still historically low, no one knows how disorderly the process might be and even less where those yields will settle, Borio said.

A particular risk was of a 'disruptive unwinding' of financial imbalances in countries that have experienced unusually strong increases in private sector debt.

"History does not offer any good guidance as to what will happen," Borio said on a conference call to present the BIS's quarterly review.

BIG DECISION, BIG STAKES

In short, a lot is riding on Wednesday's FOMC statement and news conference by Bernanke.

The consensus is that the Fed will initially reduce its bond purchases, now $85 billion a month, by $10 billion or perhaps $15 billion.

A batch of housing data this week is likely to reinforce the case for caution. Housing starts will rise, according to economists polled by Reuters, but building permits and existing home sales are forecast to dip.

Luca Paolini, chief strategist with Pictet Asset Management in London, said he expected a dovish Fed statement, especially in light of August's soft jobs report. What's more, some FOMC members might vote against any tapering at all just yet.

"But there's always an announcement effect, which in this case could be especially powerful because we are moving from free liquidity for all to a landscape where a lot of investors have the perception that we're beginning a tightening cycle," Paolini said.

EMERGING MARKETS

A rebound in many emerging market currencies and stock markets in recent weeks gives some analysts confidence that Fed tapering is now priced in and that economic fundamentals, though not great, justify scaling back stimulus.

"What we've seen in the last couple of weeks is a resurgence of expectations on the positive side, mainly because some of the leading indicators from the U.S., the euro zone and Japan are signalling more positive growth momentum this year and into 2014," said Rajiv Biswas, chief Asia Pacific economist in Singapore for IHS Global Insight, a consultancy.

And with China regaining momentum, east Asian exports should start to rebound by the fourth quarter after two years of softness, providing a platform for stronger regional growth in 2014, he said.

Julian Jessop with Capital Markets, a London research outfit, agreed that winding down what has been an unprecedented episode of monetary stimulus is fraught with risk.

"Nonetheless, the potential for Fed tapering alone to shock the markets or derail the global recovery has surely now diminished," he said in a report.

(Editing by James Jukwey)

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