Why markets are rallying on the Fed - and how economists are reacting

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The Federal Reserve surprised many observers with its decision on Wednesday to taper its monthly bond purchases starting in January, marking the beginning of the end for a key stimulus program that has been very, very good to stocks over the past several years.

But while the timing of the move was a surprise, just about everyone expected the Fed to cut back on bond purchases – known as quantitative easing or QE – within the next few months. The size of the taper, $10-billion (U.S.) from total purchases of $85-billion per month, was also expected. And, the Fed balanced the stimulus removal with some assurances.

Like: It now sees the risks to the outlook for the economy and the labour market as more balanced. It also sees "cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions." And any further tapering is not on a "preset course."

As for interest rates, the Fed made it clear that a 6.5 per cent unemployment rate will not be the trigger for increases. In its statement, it said "it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6.5 per cent" – especially if inflation is below the Fed's 2 per cent goal.

Markets, which had been nervous of Fed tapering earlier this year when it was first mentioned as a policy shift, took it in stride on Wednesday. The Dow Jones industrials and the S&P 500 closed at record highs. The Dow surged 292.71 points to 16,167.97 and the S&P rose 29.65 points to 1,810.65. The Nasdaq jumped 46.38 points to 4,070.06

Toronto's S&P/TSX composite index ran ahead 154.57 points to 13,334.73.

And the yield on the 10-year U.S. Treasury bond – which surged from 1.6 per cent in May to about 3 per cent in September – wobbled a bit but was last seen at 2.89 per cent.

Here's what some economists are saying:

Derek Holt, Scotiabank Economics: "I think the Fed may have now set itself up for a more aggressive market test across the curve into 2014 which could challenge today's post-FOMC equity rally and a sanguine response in the Treasury market.  The Fed embraced a tepid taper but signalled fairly strongly that there is further tapering to come in the January meeting and that there is a high bar to halt further near-term tapering and I'm not sure markets are getting that kind of commitment here.  The Fed also strengthened forecast guidance for the fed funds target but in a weak manner that could easily have markets testing the front-end sooner than the Fed wishes in 2014. Asset purchases were slowed to $35 billion for MBS and $40 billion for Treasuries which is $5 billion lower on each count. The markets may be encouraged by a modest taper, but I think they are missing the forward guidance on the high likelihood of additional near-term tapering.  By stating that "…the committee will likely reduce the pace of asset purchases in further measured steps at future meetings" as long as its forecasts remain on track, I think the Fed is saying they intend to taper again on January 29.  The Fed is unlikely to have enough material further forecast information by then to lead them to hold off on further tapering and so a fairly high bar has been set against any expectation that they could deviate from the path toward further near-term tapering."

Ian Shepherdson, Pantheon Macroeconomics: "This is a toe in the tapering water, the absolute minimum reduction the Fed could announce without looking timid. Still, it is the first step away from incremental easing since July 2006, so it is significant. The point here is that 'cumulative progress' towards full employment is cited as the key driver of the decision, so we now have to assume further tapering in first quarter unless payroll growth slows, or financial conditions worsen markedly."

Andrew Grantham, CIBC World Markets: "The unemployment rate projection for the end of 2014, now 6.3-6.6 per cent shows that Fed officials see the real possibility of hitting 6.5 per cent before the end of next year, and will be one of the reasons why the statement stressed unemployment would have to move well past that level before rate hikes would be forthcoming. On a slightly more dovish note, 3 participants now expect the first rate hike to come in 2016, compared to only 2 in the previous projections, presumably due to the softer inflation profile."

Paul Ashworth, Capital Economics: "The median FOMC forecast suggests the fed funds rate will end 2016 at only 1.75 per cent. That perhaps helps to explain why, so far at least, bond and equity markets appear to be taking the tapering announcement in stride."

Paul-André Pinsonnault/Krishen Rangasamy, National Bank Financial: "The first step in the reduction of the Fed's asset purchase program is rather modest in size, and as such shouldn't wreak havoc on markets. Given that the Fed's central tendency for 2014 GDP growth is more than decent, we think that tapering will accelerate over the year and QE will be completely wound down by the end of the third quarter of 2014."