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Fed policy, but not as we’ve known it

Fed policy, but not as we’ve known it

“Vast and vastly complex.” That’s how Janet Yellen, Chair of the U.S. Federal Reserve (Fed), recently described the U.S. economy – and she’s right. Not only is the Fed faced with steering the world’s largest economy towards a more ”normal” level of interest rates, but it is doing so in a period of particular uncertainty.

And with interest rates on a rising path, speculation is growing over what the Fed will do with the $4.5 trillion it holds in government bonds. So what might we expect from the Fed in the months ahead?

The sheer size of the U.S. economy means U.S. monetary policy matters. The U.S. accounts for over 20% of global output and more than a third of global stock market capitalization. It is prominent in almost every global market, making up around 10% of world trade flows, a fifth of the stock of global foreign direct investment and almost the same share of energy demand. And since the U.S. dollar is the most widely used currency in global trade and financial transactions, developments in U.S. monetary policy and investor sentiment play a major role in driving financial conditions worldwide.

Fed determined to raise rates

Although the Fed is firmly on a path to increased interest rates, it is not immune to shocks. Unexpected shifts in the oil price, global activity, the rate of productivity growth and financial stability could all knock the U.S. economy and the Fed off course.

Since last November’s presidential election, fiscal policy has been in particular focus. Many forecasters have raised their U.S. inflation outlook and gross domestic product (GDP) growth forecast on the back of the election result.

But the economic impact of any fiscal package will depend on its size and timing. The amount of spare capacity in the economy, how effective the boost is in raising the economy’s supply potential, and the government’s debt position also matter. If spare capacity is limited, it could feed into inflation more than “real” activity, forcing the Fed to raise interest rates faster than anticipated. If the fiscal boost does more to add to government debt than the economy’s supply potential, longer-term interest rates could also rise, reducing U.S. firms’ and households’ spending on interest-sensitive goods and rippling out across global financial markets. Equally, if the fiscal boost raises the economy’s potential by more than anticipated, activity could pick up with less of a need for inflation-dampening rate rises.

In this uncertain environment, the Fed is focused on economic fundamentals.

In this uncertain environment, the Fed is focused on economic fundamentals, pointing to further rate rises ahead. The U.S. economy is close to maximum employment, and inflation is moving towards the Fed’s goal. The addition of a net 15.5 million new jobs in the past seven years has lowered the unemployment rate to 4.7%, around pre-recession levels.

Inflation is rising, with the core personal consumption expenditures (PCE) index up nearly 1.5% in the year to November 2016 (the latest reading), compared with only 0.5% during 2015. This considerable economic progress prompted last December’s interest-rate rise.

Inflation likely to continue rising

Source: Oxford Economics, December 17, 2016. For illustrative purposes - Forecasts are offered as opinion and are not reflective of potential performance, are not guaranteed and actual events or results may differ materially.

Janet Yellen has also acknowledged the risk of “undesirable increases in leverage and other financial imbalances” if interest rates remain at very low levels for much longer.

Gauging exactly when the Fed will act again is difficult, given the uncertainties. Penciling in at least two rate rises for 2017 seems a reasonable bet, however, with the first coming by mid-year – if the fundamentals continue to strengthen and market sentiment, towards fiscal policy specifically and the U.S. economy more broadly, remains positive.

What about the Fed’s balance sheet?

Fed speakers have started discussing the issue of the Fed’s balance sheet, which has swelled to $4.5 trillion due to the purchases it made as part of the policy of quantitative easing. Philadelphia Fed Chief Patrick Harker has suggested that the Fed should “start serious consideration of first stopping reinvestment and then over a period of time unwinding the balance sheet” once short-term interest rates reach 1% - which, on current Fed expectations, will happen this year.

For the Fed itself, the motivation for tackling its balance sheet is at least twofold. First, it is sensitive to criticism over inflation and asset-bubble risks. Second, changes in longer-term interest rates driven by balance-sheet reduction can help dampen domestic inflationary pressures, in a similar way to increases in short-term interest rates – but with potentially less of an impact on the exchange rate.

A change in focus

But balance-sheet reduction would mark a significant change in policy, with risks attached. At present, the Fed reinvests the proceeds of maturing bonds, thereby keeping its policy neutral and maintaining the size of the balance sheet. To smooth its scaling back, and lower the risk of a negative market response, the Fed looks likely to reduce its reinvestment activity gradually. But this approach is not risk-free. If the Fed starts paring back its investments at the same time as the Trump administration issues longer-dated debt – as has been mooted – bond market indigestion could ensue. As bond yields rise and prices fall, the attractions of bonds relative to equities may increase, potentially hitting equity markets.

Another “taper tantrum?”

There are also concerns about the impact of rising borrowing costs on the housing market, given the Fed’s portfolio of mortgage bonds currently amounts to nearly 20% of the domestic market. More broadly, investors may fear a global ”taper tantrum,” similar to the market’s reaction in 2013 when then-Fed Chair Ben Bernanke suggested the Fed could pare back the scale of its asset purchases. And how any new members of the Fed’s rate-setting committee may feel about these issues – Mr. Trump has room for two appointments this year, not to mention a new Fed chair in 2018 – remains to be seen.

The Fed’s balance sheet is a legacy of its purchase of bonds and mortgage-backed securities during the financial crisis. Starting its reduction will therefore be a highly symbolic move. With all this complexity and risk in play, however, the current discussion among Fed officials looks to be more of an early testing of the waters than a prelude to immediate action.

Important Information

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase). The Fund's investments in high yield bonds and other lower-rated securities will subject the Fund to substantial risk of loss.

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