Federal Reserve Policy: What’s Next?

Federal Reserve officials continue to emphasize that mone­tary policy will remain data dependent. While the pace is uncertain, future short-term interest rates are expected to rise gradually over the next couple of years. The unwinding of the balance sheet has begun slowly, but the pace will pick up over the course of next year.

INFLATION

Much of the recent monetary policy debate has focused on the low inflation trend. Fed officials note transitory effects on inflation, such as the sharp drop in wireless telecom services in March, and most believe that tighter labor market condi­tions will lead to higher wage inflation. Yet, they are also aware that longer-term structural changes may make the inflationary response to low unemployment more muted than in the past. Time will tell. Officials have signaled a willing­ness to wait for more information.

INTEREST RATES

While the Fed has raised short-term interest rates in the first half of the year (still very gradual by past standards), credit has generally gotten easier, suggesting that there is more work to do in order to get the economy on a more even keel. Fed Chair Janet Yellen has said that the federal funds target rate is not far below what would be considered a “neutral rate,” a level neither contradictory nor expansionary. However, the neutral rate is expected to rise over time as the economy improves – hence, an outlook of gradual policy rate increases.

During the financial crisis, the Fed effectively hit the lower bound on short-term interest rates. Large-scale asset pur­chases, commonly called “quantitative easing” or QE, were further accommodation. The balance sheet surged as securities were added to the Fed’s portfolio. The Fed has now begun to unwind that. The Fed telegraphed its inten­tions and the pace of the reduction, so market reaction to the announcement has been limited.

It’s estimated that QE lowered the 10-year Treasury yield by about 100 basis points. Therefore, the balance sheet unwinding is expected to raise long-term interest rates in the quarters ahead (and this will be a multi-year process). Importantly, the Fed does not view the balance sheet unwinding as “active” policy. Rather, it’s been described as “background.” Officials have empha­sized that the federal funds target rate will remain the main policy lever.