5 Exaggerated Stories About The Fed

REUTERS/Gary CameronA tourists uses a video camera atop a Big Bus double-decker tour bus as the tour passes the Federal Reserve Building headquarters in Washington, on the second day of a U.S. government shutdown, October 2, 2013.

The Federal Reserve has incredible power, and the decisions it makes have profound implications for the global economy.

All eyes are on the Fed as it plans to taper its stimulative quantitative easing program, which consists of the monthly purchases $85 billion worth of bonds.

With the Fed getting increasing prominence in the news, more and more people have become self-proclaimed experts on the institution.

And this has led to plenty of confusion about where the Fed stands and what it can do from here.

"Does the Fed change its reaction function every month?" asked Bank of America Merrill Lynch's Ethan Harris. "Market sentiment around the Fed has swung dramatically in the past six months-in the spring it was "QE infinity," by the fall it was "tapering regardless of the data" and more recently some seem to again see QE infinity. This swinging pendulum in part reflects an endless array of exaggerated stories about the Fed exit."

In a research not to clients on Thursday, Harris laid out five exaggerated stories and pointed out their problems.:

• Janet Yellen is a super dove and will delay pulling the trigger as long as possible. No, she may be a dove, but she is well within the mainstream of the Fed. Moreover, she will face a more hawkish set of voting members than Bernanke did this year. Overall, we expect little change in the way the Fed operates if Yellen is the new chairman.
• The Fed missed a great "opportunity" to taper. Yes, the core members of the Fed are slightly uncomfortable with the ever growing balance sheet, but, no, they are not "itching" to get out of QE. When they adopted QE3 and tied policy to the economy, they were well aware of the potential impact on their balance sheet. The Fed can exit whenever the data justify it.
• The Fed now knows it can't exit without crushing the markets. In our view, the normal panic around a Fed exit has already happened with the term premia rising back into positive territory this summer. Moreover, if the exit comes with better data rather than just with a forecast of better data, markets should feel more comfortable about what the Fed is doing.
• The Fed cannot taper until the fiscal outlook is clear and that could take years. The fiscal battles are one of several headwinds facing the economy. If the fiscal battles heat up again, they could cause the Fed to hesitate, but unless they hurt growth on a sustained basis they won't stop the Fed exit.
• The economy is on Fed life support and will never be able to stand on its own. The Fed's super easy policy has been helpful in sustaining growth in the face of some major headwinds and has contributed to significant healing in the underlying health of the economy. However, balance sheets have now improved dramatically, the worst of the foreclosure mess is behind us and banks are slowing re-engaging. Moreover, we do not expect any new austerity or confidence shocks out of Washington next year. The economy should be able to leave intensive care next year.

"The Fed call has been and will be about the economy," said Harris.

If GDP growth picks up, the Fed will taper. And if inflation stays low, the taper will happen slowly.