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.
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.
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.
The near-term outlook remains constructive for the stock market. The economy continues to expand, but not so fast that the Fed rushes to “take the punch bowl away.” However, demographic constraints (slower growth in the labor force) will restrain GDP growth and perhaps present some challenges for the markets in the months ahead.
While future monetary policy moves are always uncertain, the future appears more clouded as we look beyond the early part of 2018. Trump will have a number of Fed governor positions to fill and will be able to shape the Fed’s leadership. The choice of Fed chair remains key. Ben Bernanke and Janet Yellen were the right people at the right time.
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