The Federal Reserve is likely to taper bond purchases by a further $10 billion to $55 billion a month at its policy meeting this week and may stop buying by the end of the third quarter as the economy reaccelerates.

The chart shows a long history of the “headline” policy rate* together with an indicator** designed to summarize data influences on the Fed’s thinking. The indicator gave advance warning of changes in interest rate direction up to and including the 2008-09 crisis, and has been informative about QE policy more recently.

The indicator was below zero, suggesting policy easing, when the Fed launched QE1 and QE2 in December 2009 and November 2010 respectively. It turned significantly positive in early 2011, however, signalling that QE2 would not be extended beyond its scheduled end in June. A renewed slide towards zero during 2012 preceded the launch of QE3 in September of that year and its expansion in December.

The indicator had been recovering for several months when the Fed announced tapering in December 2013. It has risen further in early 2014 and is just below its level ahead of the suspension of QE2 in June 2011.

Monetary trends signalled that economic growth would moderate in early 2014 but are now suggesting another pick-up from mid-year – see previous post. If correct, the policy indicator may stabilise near term before pushing higher again in the summer. Economic reacceleration may cause the Fed to end QE3 in July or September rather than in the fourth quarter, as implied by tapering of $10 billion per meeting.

*The Fed has announced publicly its target for the Fed funds rate since February 1994; the discount rate was the immediately visible policy rate before that date.
**The indicator is based on changes in core CPI inflation and unemployment and the ISM manufacturing vendor deliveries index, which measures supply chain delays. The latter two components are responsible for the current positive reading.