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The Fed Up Close: The Changing Face Of Monetary Policy

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March 31, 2016
The Federal Reserve's money faucet: How federal monetary policy can affect your investments

Job title: Federal Reserve Chair

Job description: In charge of the nation's monetary policy, must testify before Congress on a semiannual basis, meet with other banking types regularly to flip the switch on interest rate moves in the U.S. Some would call this position the captain of the nation's economy.  

Can you say job stress and pressure? When Janet Yellen took the reins of the nation's central bank from former Chair Ben Bernanke, she inherited a monetary policy that will go down in the history books. We’re talking a historically low, near-zero interest rate policy that had been around since the Great Recession began in 2008; a massive, never-before-seen $4.5 trillion balance sheet (compared to a pre-crisis figure of $800 billion in 2008); and an economy that churned out positive but stubbornly sluggish growth and inflation numbers.

Fast-forward to 2016. My, how quickly things change. From December 2015, the Federal Reserve had broadcast its intentions to hike interest rates four times in 2016. But the pesky financial markets got in the way of the Fed’s plans. Now, markets have downgraded expectations to as low as just one or even no interest rate hikes for the remainder of 2016.

Fed Chair Challenges

What are the challenges Chair Yellen faces now, and what can traders expect going forward? First, let's look at interest rate expectations. "Markets have priced out a chance of a rate hike throughout 2016. We think we still see potentially two hikes," says James Marple, senior economist at TD Bank Group. "The outlook for the economy is not great, but not recession. The bond market has gone too far."

The key message: don't be surprised if the Fed still follows through on interest rate hikes in 2016. "By June we see an above 50% probability that a Fed rate hike is on the table," Marple says. He adds that this will be data dependent, and also assumes a calmer atmosphere in the financial markets.

What About That Dual Mandate?

"There seems to be a disconnect with fears in the financial market that suggest the U.S. economy is on the cusp of heading to a recession. Nothing in the hard economic data outside of the financial markets should lead you to that conclusion," Marple says. The labor market has been improving recently, and economists aren't concerned about that half of the Federal Reserve's dual mandate, which includes establishing a policy that stimulates maximum employment and stable prices.

It’s the second half of that equation, inflation, that’s been the Fed's bugaboo. Stubbornly low inflation has triggered concerns about potential deflation in recent years. Just recently, however, encouraging signs have emerged on that front. The Fed's preferred inflation gauge, personal consumption expenditures or PCE (see figure 1), revealed a 1.7% year-over-year gain in its core rate in January, finally getting closer to the central bank's 2% target rate. 

PCE as an inflation gauge

FIGURE 1: PCE YEAR-OVER-YEAR CHANGE FROM 2008 TO 2016.

Inflation might be getting closer to the Fed’s 2% target, seen in the recent rise of personal consumption expenditures. Data source: U.S. Bureau of Economic Analysis. Image source: research.stlouisfed.org. For illustrative purposes only. Past performance does not guarantee future results.

Brace yourself: there could be more inflation in the pipeline. "The markets are underestimating the inflationary pressures that are building," says Ryan Sweet, director of real-time economics at Moody's Analytics. "The biggest declines in oil are behind us. Medical care costs will increase in 2016. We are seeing a very tight rental market, which is causing additional rent increases. Rents make up a good portion of the CPI [Consumer Price Index]," Sweet noted.

Moody's Analytics also forecasts the Fed to move ahead with two or three interest rate hikes this year. Stay tuned.

A Brave New World: Negative Interest Rates

Other hot topics among the central banking crowd include negative interest rates. Yep, you got that right. A decade ago, this was unheard of. But today, a number of major global central banks have adopted a negative interest rate policy, including Japan, the eurozone, Switzerland, Denmark, and Sweden. Once central banks hit the zero level of interest rates, some have turned to negative interest rate policy as another method for stimulating economic growth. The theory is that negative interest rates encourage banks to withdraw excess reserves from the central bank (where they are now paying to store it) and instead lend it out to businesses and consumers. Does it work? That’s still up for debate; keep watching the eurozone and Japan.

Still, it raises the question: could the U.S. be next? The official federal funds rate remains extremely low by historical standards (see figure 2), and isn’t all that far away from zero. Not likely, says Sweet. "The U.S. economy would have to fall off the rails for the Federal Reserve to consider negative interest rates," he says.

Federal funds rate

FIGURE 2: EFFECTIVE FEDERAL FUNDS RATE FROM 2000 TO 2016.

The official federal funds rate has remained near zero since the financial crisis in 2009. Data source: Board of Governors of the Federal Reserve System. Image source: research.stlouisfed.org. For illustrative purposes only. Past performance does not guarantee future results.

There remain more questions than answers about the impact from negative interest rate policies, which some fear would inspire a flight to cash-stuffed mattresses. Marple called negative interest rates for the U.S. "a brave new world that I don't think anyone wants to get into." Negative interest rates destroy net interest margins for banks, he explains. "At some point the only way banks can make up for that is to charge retail customers. There are risks that threaten the health of the financial system by pushing too far in this direction," he warns.

For now, rest easy. "This is an unlikely tail-risk" scenario for the U.S, Marple says. "We are already through the bulk of the disinflationary impulse from lower oil prices. Inflation is more likely to trend up than down over the year.”

With inflation creeping up behind the scenes, investors might consider the possibility that the Fed may deliver more hikes than are currently expected this year. As investors unwound expectations for rate hikes early in the year, it drove yields on the 2-year and 10-year Treasuries to 0.78% and 1.75%, respectively, in late February. Although investors have been hearing this for a long time, it’s still the case that higher rates are coming. By year-end 2016, Marple says his group expects 10-year Treasuries at 2.30% and the 2-year yield at 1.25%.

How Will the Fed Affect Your Investments?

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