Don’t fear the end of Fed QE

Today will be a big day for markets. The Federal Open Market Committee will wrap up its monetary policy meeting, and traders will also be waiting for news from Chairman Ben Bernanke at his post-meeting conference.

Bernanke will provide insight on the FOMC’s forecast for the U.S. economy, “and hopefully he’ll provide clarity on how QE tapering will play out,” says Michael Gregory, senior economist at BMO Capital Markets.

Though Gregory doesn’t anticipate any changes this afternoon—that would be a huge shock to markets—he says the Fed should encourage the shift of expectations. If the Fed starts preparing investors for QE changes now, markets can then start pricing in the tapering of bond purchases.

Read: QE pullback could end equity run

In Gregory’s view, this wind down will occur in stages. Officials will start by cutting purchases by a third in Sept from $85 billion to $55 billion, and they’ll then knock them down to $25-to-$30 billion in January. He adds, “They’ll start the process before Bernanke’s potential departure in January, and any chairman after him will have a much easier job. Policy won’t change.”

What’s even more promising is the Fed has started to move away from claims it would sell its bond holdings once QE ends. He says this will encourage investors and benefit markets.

One of the main reasons markets are currently volatile is due to the fear officials will start tightening monetary policy soon after easing ends. “But that’s not how the situation would play out,” says Gregory. “Historically, there’s approximately a year between the end of QE and the raising of rates” since officials often wait until the economy starts gaining momentum.

The Fed has also stated it plans to depress interest rates long after it ends bond purchases, which would allow for economic recovery.

Right now, the housing sector is the main driver of the U.S. economy since it’s creating job growth, and since people are starting to take out mortgages to buy houses rather than refinances their homes. Gregory says, “While we don’t have consistent job growth right now, we’re getting there. We could be in a much better situation in a matter of months.”

Read: Canadian housing to hold steady in 2013

And while the end of QE might cause short-term volatility, he says the economy improving is great news, and that’s the message Bernanke will likely drive home tomorrow during his conference.

“Interest rates may start to go up, but the economy will be able to handle it,” adds Gregory.

What’s more, Gregory adds the current level of inflation has “been surprising since the its movement been so slow. This relates to how retailers have been pricing product, given they’ve been worried about issues such as the so-called sequestered spending cuts in the U.S. They’ve been cautious [and have] been limiting the price increases they pass through.”

Read: U.S. consumer prices rise 0.1%

In fact, “they’ve been cutting prices and that’s put a lot of downward pressure on inflation.” But, he points out, “The good news is the more favourable the low-inflation environment becomes, the less likely the Fed will raise interest rates.”

So though the Fed may stop purchases altogether early next year, we likely won’t get an interest rate increase until well into the end of 2015. Gregory says Bernanke will stress this point before tapering begins to ensure investors remain levelheaded.

Read: Inflation isn’t a threat…for now

Gregory suggests investors monitor market activity when QE ends.

“If [people have] been competing with the Fed or have been selling into it, they’ll be impacted since a major investor won’t be actively buying. Even if the market does price in tapering, we’ll still have to see what the overall impact might be, given the Fed’s infusion of billions into markets will no longer be there.”