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Why the Fed is testing new monetary policy tools

Why the Fed is testing new monetary policy tools (Part 1 of 5)

Must-know: Monetary policy outlook according to Dr. William Dudley

Monetary policy outlook

With the labor market improving at a brisk pace and inflation gradually inching higher, focus has shifted to when the process of raising the Fed funds rate will start and what path the Fed funds rate will take in the future.

The Fed funds rate has remained near zero in the aftermath of the great recession. Since the interest rates were low, Treasury bond (TLT) yields remained low. With improvement in the economic fundamentals in the last few quarters, the credit spread of investment-grade (LQD) and high-yield (HYG) bonds over Treasury bonds has narrowed and stands at an all time low. The improvement in economic fundamentals has also propelled stock market indices such as the S&P 500 (VOO) and the Dow Jones Industrial Average (DJI) higher over the last year.

Fed Funds rateEnlarge Graph

Dr. Dudley advocated the current pace of taper and emphasized that the focus will shift on when the Fed funds rate will increase and how the Fed will manage its bloated balance sheet.

He said that the evolution of recovery matters when deciding on the timing to increase the Fed funds rate. If the economy improves faster than projected, the Fed funds rate will see a rise earlier than expected. Otherwise, the rise in the Fed funds rate will be delayed.

While deciding on the trajectory of the rate increase, the evolution of the economy matters. Dr. Dudley feels that the rate of the increase in the Fed funds rate will be slow. However, how financial markets react to the rate hike may decide the future path of interest rates. If markets react mildly, as in the case of ongoing tapering, the pace of increase in interest rates could be faster. Otherwise, a more cautious approach is needed.

To learn more about Mr. Dudley and why investors should pay attention to his speech, continue by reading the Market Realist series Why investors should pay attention to William Dudley’s speech.

Continue reading the next section of this series to learn why Dr. Dudley thinks that the Fed funds rate would remain lower than the long-term average for the next few years, continue reading the next part of this series.

 

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