How You'll Know On Wednesday Whether Or Not The Fed Is Likely To Begin Tapering In September

Right now, the Federal Reserve is buying $85 billion of bonds every month, indefinitely: $45 billion of U.S. Treasuries and $40 billion of mortgage-backed securities.

If the Wall Street consensus proves correct, however, the Federal Reserve is slated to announce its first reduction in the pace of its bond buying program known as quantitative easing (QE3), which the central bank launched in September 2012.

Given the heightened sensitivity of markets to this possibility – which is widely seen as contingent on improvement in the economic data, Deutsche Bank economist Joe LaVorgna says market participants should be ready for two key events this week: the release of the minutes from the Federal Reserve's July FOMC meeting on Wednesday, and the release of the latest initial jobless claims data on Thursday.

The July FOMC minutes will probably contain clues about whether or not the Fed is likely to go forward with tapering QE3 as soon as September, according to BofA Merrill Lynch economists.

In a note to clients, BAML's U.S. economic team previews the release:

The July minutes may give some insight into just how strong the conviction level at the Fed is for tapering in September. The July statement had few changes, but those were modestly cautious and dovish. The minutes are likely to sound more hawkish – recall that has been the case all year long, in part because they give a platform to more hawkish non-voters – which presents a risk that markets will again sell off on the minutes. We see the voting members largely split into two groups: those who emphasize the "cumulative progress" in the economy and thus favor tapering soon, even if the latest data disappoint slightly, and those who want to see "better momentum" and thus may prefer to wait. We recommend keeping a close eye out for discussions of what factors various members see as most important for the tapering decision – particularly interest rates, as the FOMC cited higher mortgage rates as a potential risk in their July statement.

If the Fed is close to a September taper, then we would expect some discussion of operational details in the minutes, such as how much to taper and in which assets – MBS or Treasuries. Our base case is that the Fed will taper equally in both assets. Recent Fed commentary has proposed a token-sized first cut to the purchase pace. We expect some debate over all these issues but no resolution – the nature of the taper is likely to be a "game-day" decision, and there are many possible intermediate scenarios between no taper and current market expectations. Of particular interest will be any discussion of how they plan to signal subsequent tapering moves. We doubt this would be through explicit economic thresholds on asset purchases, but will watch for discussion on this issue. We also would not be surprised to see some discussion about strengthening forward guidance on interest rates as well, but we see a small risk that they signal any planned changes in the minutes. We suspect that it is too soon to reduce the 6.5% guidance on the unemployment rate, and with the additional language in the recent statement about the risks of persistently low inflation, we don't expect a lower-bound inflation threshold. As always, we will also keep an eye out for other proposed communication innovations.

The Fed will release the minutes from the July FOMC meeting on Wednesday at 2 PM ET.