Market players will be watching intently this week for clues that the U.S. Federal Reserve is about to begin scaling back its huge monetary stimulus, a key support of stock and bond prices.
Markets have been roiled by confusing signals from Fed chairman Ben Bernanke and other officials, although recent data provide little firm reason for the central bank to change course on Wednesday when it provides its latest outlook on interest rates and the economy.
Indeed, the International Monetary Fund cautioned the Fed on Friday against cutting stimulus this year, as the risks to growth have been "modestly tilted to the downside" by automatic spending cuts.
Mr. Bernanke indicated in May that the Fed could soon reduce asset purchases – now totalling $85-billion (U.S.) a month – if warranted by an improved labour market. In response, yields on 10-year Treasuries jumped, and investors have also been bailing from other high-grade and high-yield bonds, as well as equities, out of concern that Fed tapering would hit the value of other assets.
Most analysts expect the Fed this week to maintain its aggressive program of "quantitative easing," or QE, while clarifying its intentions.
"The current state of affairs in the real economy suggests that the FOMC [the Fed's policy-setting Federal Open Market Committee] is unlikely to come to any new or different conclusions regarding the appropriate course for monetary policy," Aneta Markowska, senior U.S. economist with Société Générale, said in a note.
Economic data since the last meeting, she said, "can only be described as lukewarm: not hot enough for the Fed to send a stronger tapering signal, and certainly not weak enough to even contemplate increasing the pace of asset purchases."
The Fed explains on its website that clear communication "is always important in central banking." But it was a failure to provide clarity on whether or when monetary stimulus would be rolled back that triggered the sort of market instability the bank was hoping to prevent when it got into the business of providing guidance in the first place.
"The Fed really has had a hard time communicating in an environment where what it says is so important and where the future is uncertain," said Robert Brusca, chief economist with Fact and Opinion Economics in New York. "The Fed has leaned hard on this idea that it has forward guidance. But it's kind of silly to think you can give the market forward guidance when you don't know what's going to happen going forward."
The central bank has faced a barrage of criticism for not outlining a clear exit strategy. "That's different from what its policy is," said Mr. Brusca, a long-time Fed watcher. "It's not that its policy is so bad. It's that people don't really seem to understand what the Fed is planning to do."
Part of the failure to communicate stems from public comments by hawkish officials who have argued the Fed should be cutting back asset purchases.
"I don't want to go from Wild Turkey [bourbon] to cold turkey [on easing]," Richard Fisher, president of the Federal Reserve Bank of Dallas, said in a recent interview.
"But I do think we should pare back. … We will not build our balance sheet to infinity. At some point, it stops," said Mr. Fisher, who does not have a vote this year on the FOMC.
Even proponents of large doses of QE have acknowledged the time will soon be coming for the Fed to scale back. And financial markets have been paying attention. "The markets are beginning to socialize the idea that this does not go on forever," Mr. Fisher said.