MORGAN STANLEY: The Fed Has 'Heavy-Caliber Ammunition In Reserve'

This Wednesday, the Federal Reserve will conclude its two-day Federal Open Market Committee (FOMC) meeting, which is when economists expect the Fed to announce the tapering of its monthly purchases of $85 billion worth of Treasury securities and mortgage-backed bonds.

These large-scale asset purchases, also referred to as quantitative easing (QE), have been intended to keep interest rates low to stimulate the economy.

And the tapering represents confidence that the economy is indeed getting better.

"We think it will trim Treasury purchases $10 to $15 billion in a sequence that will take nine months to get to zero net acquisitions," said Morgan Stanley's Vincent Reinhart. "Fed officials have said over and over again that the balance-sheet decision is made meeting-by-meeting and is data-driven. In the event, the payroll employment report for August must have proved a disappointment to them and the back revisions pointed to less progress in hiring than they hoped. A small tapering and tilting toward Treasuries acknowledges those inconvenient facts."

But what if interest rates start surging in an a way that threatens the economy?

Well, the Fed has other tools. Here's Reinhart:

...True, Fed officials have used QE in the past to signal the Fed's willingness to keep policy accommodative for a considerable period. But that was then. Now they can signal the intent to keep policy accommodative-the forward guidance so much in vogue among central bankers-by adjusting their threshold on unemployment or introducing a lower bound on inflation. With this heavy-caliber ammunition in reserve in the event yields back up uncomfortably later in the year, they can put QE on the road to retirement. For the incumbents at the Fed, starting now puts a body in motion that will stay in motion for the next leader.

Currently, the Fed employs an unemployment rate threshold of 6.5% and an inflation rate threshold of 2.5% to help guide monetary policy. In other words, as long as unemployment stays high and prices remain low, the Fed will continue to do what it can to keep rates low.

And QE isn't the only tool it has to accomplish this goal.