Federal Reserve governors and regional bank presidents, in Washington for a monetary policy meeting, are wrestling with the question of the "taper" — whether to scale back the open-ended $85 billion monthly bond program they initiated last December.
Chairman Ben Bernanke at the end of 2012 set out a three-part test for ending the asset purchases, which he said were merely intended to create "some near-term momentum in the economy": The Fed would reduce the purchases when it saw "increasing growth that’s picking up over time...; continuing gains in the labor market; and inflation moving back towards" the Fed's 2 percent objective.
Two parts of that test have been more or less met.
Growth has picked up, albeit slowly. Here is real gross domestic product growth by quarter:
and the labor market has improved. Both the unemployment rate (in red) and the underemployment rate calculated by the Bureau of Labor Statistics (in green) have fallen fairly steeply over the past year:
one missing ingredient, however, is inflation. Inflation is still well below the Fed's 2 percent goal, both as measured by the consumer price index and as measured by the personal consumption expenditures index, stripping out food and energy, which the Fed considers the more accurate number:
With the program's completion ambiguous, according to these criteria, most analysts agree that it's a close call whether the Fed will bring its purchases down from $85 billion or keep them at the same level for a few more months. Only 20 percent of 42 money managers and economists polled by CNBC expect the Fed to announce the taper with Wednesday's scheduled press conference. But a plurality say it will come at the Fed's next meeting in January.
As the year ticks down, it's clear that the Fed will begin winding down its stimulus asset purchases soon -- the only question is how soon. Bernanke has been preparing for such a move in recent weeks, indicating that the Fed would rather rely on near-zero interest rates, and promises to keep those rates low into the future, than quantitative easing to keep money loose.
Bernanke has stressed on multiple occasions that tapering is not tightening — that is, investors and businesses shouldn't expect monetary conditions to tighten even if the Fed does taper. He and other Fed officials, including his presumptive successor Janet Yellen, have tried to reassure markets that forward guidance can be just as powerful a stimulus tool as buying bonds.
"For monetary policy, expectations matter," Bernanke said at a Nov. 19 dinner speech in Washington. If Bernanke is right, markets won't move drastically in response to the Fed tapering, because the Fed has worked hard to set the expectation that low interest rates will do the work instead.
If, however, markets do react to the Fed's announcement, it would be a sign that Bernanke has failed to communicate the point of the Fed's plans sufficiently. Bernanke admitted that the significant market reactions to previous meetings in which he discussed the possibility of a taper showed that investors either did not understand or did not fully believe the Fed's promises regarding the mix of stimulus tools.
Wednesday is likely Bernanke's last chance to get his communications strategy right, as it is the last scheduled press conference during his tenure. If there is still market confusion about the Fed's plans, it will be up to Yellen, who still awaits a confirmation vote in the Senate, to make the transition.