“The path of the economy is uncertain, and effective policy must respond to significant unexpected twists and turns the economy may take.” – Janet Yellen
We have not written much on the Federal Reserve since our Fed Ed series that we published last fall in conjunction with our screening of Money for Nothing: Inside the Federal Reserve, so we wanted to use today’s Insight to provide a brief update on the latest Fed actions and the state of monetary policy in America. As we write, Janet Yellen is presenting the first of two days of testimony to Congress. This is a semiannual ritual in which the Federal Reserve Chair delivers prepared comments and is then subjected to grueling questioning, first by the Senate Banking Committee and the following day by the House Financial Services Committee. All eyes and ears are fixed on any additional guidance and insight Ms. Yellen might provide into when and how the Federal Open Market Committee might begin to shift its policies.
Yellen’s last testimony was given back in February. Since that time the unemployment rate has fallen to nearly 6% and inflation data has begun to creep up towards the Fed’s long term target of 2%, both seen as key inputs in the Fed’s consideration of when to withdraw monetary stimulus. Yellen tipped her hat to these developments in her remarks this morning,
“The economy is continuing to make progress toward the Federal Reserve’s objectives of maximum employment and price stability.”
But she left no doubt that the Fed continues to view the labor market recovery as half-baked,
“Labor force participation appears weaker than one would expect based on the aging of the population and the level of unemployment. These and other indications that significant slack remains in labor markets are corroborated by the continued slow pace of growth in most measures of hourly compensation.”
Regarding the economy, the Fed continues to believe that growth will be moderate but consistent over the next few years. The first quarter of 2014 was certainly a major speed bump with US GDP falling at a 2.9% annual pace. Due to the perceived impact of extreme weather conditions, the first quarter is being written off as an aberration, and growth is expected to bounce back sharply and remain positive for the duration of the year.
Understanding the Fed’s view on the economy, job market and inflation is important to the extent that these views will ultimately lead to changes in their two primary policy tools: asset purchases (quantitative easing) and interest rates. At this point the winding down of the Fed’s quantitative easing program is all but a foregone conclusion. The first “taper” of the current program occurring in December when the Fed reduced its monthly asset purchases by $10 billion from $85 to $75 billion. Since then it has steadily been reducing its purchases, and has signaled to the market that it is prepared to make the final taper at its November meeting.
The winding down of QE is viewed with so much certainty that it really is not even a point of focus for market participants or the financial media any more. The focus, as a result, has shifted to the next obvious question – when will the Fed begin to raise short-term interest rates? On this topic the Fed has remained characteristically ambiguous. There is still an ample amount of uncertainty as to how this economic recovery will play out in the coming months, and the Fed will continue to digest each piece of data as it becomes known. Per Yellen,
“There's no formula and there's no mechanical answer that I can give you about when the first rate increase will occur.” … “We need to be careful to make sure that the economy is on a solid trajectory before we consider raising interest rates.”
We probably won’t have real clarity on the timeline for future rate hikes for at least another two quarters, but most pundits believe, and Fed officials have suggested, that the first hike will likely come sometime in the first half of 2015. Regardless of the timing, we believe it’s safe to assume the next rate hike cycle will be long and gradual as the Fed attempts to manage the variety of economic risk posed by a sudden spike in rates.
All in all, the relatively uneventful year thus far has been a welcome reprieve from the monetary fireworks that we’ve grown accustomed to since the financial crisis. With Janet Yellen at the helm, the Fed seems content to move gradually and consistently towards normalizing its policies. Quantitative easing (the program commonly referred to as “money printing”) will be a thing of the past in just a few short months, and near-zero interest rates could also be on their way to more normal levels by this time next year. Barring a major shift in the economic outlook this means that we are nearing the tail end of one of the most abnormal and contentious periods of monetary policy in our nation’s history.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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