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Why new faces at the Fed will impact the Fed funds rate

Part 4
Why new faces at the Fed will impact the Fed funds rate (Part 4 of 4)

Doves and hawks: Why do changes at the Fed matter to investors?

The communication from new Fed officials Fischer and Mester is likely to grab market attention

As we mentioned in Part 2 of this series, the Fed’s three major monetary policy tools—the discount rate, reserve requirement, and open market operations—influence the demand for and supply of balances held at Federal Reserve Banks by depository institutions and ultimately the level of the Federal funds rate, the base rate for the whole economy. Changes in the base rate, which has been at near-zero levels since December 2008, would likely impact both fixed income markets (BND) as well as equity markets (VOO). The members of the FOMC vote on policy that would influence the level of the Fed funds rate. So markets are extremely interested in the leanings of FOMC members, which would provide a hint on the timing and level of the base rate.

Part 4.2Enlarge Graph

What are “doves” and “hawks”?

Dr. Stanley Fischer’s appointment to the Board of Governors also makes him part of the 12-member FOMC. As the Cleveland Fed has a vote on FOMC this year, the new president and CEO, Loretta Mester, will be voting on policy decisions right away. Any new appointments to the board will also impact the FOMC composition and therefore decisions on the Fed funds rate. Markets in particular will be watching for signs that characterize current and future members of the FOMC as a “dove” or a “hawk.”

In monetary policy parlance, a “dove” generally tends to focus more on higher employment, while the “hawks” are more concerned with the central bank’s inflation targets. Some central bank officials take a centrist stance. However, investors should note that these conclusions markets’ and not necessarily the Fed officials’ themselves.

Balancing the Fed’s dual mandate

The Fed has two chief mandates: ensuring price stability in the economy through inflation targeting and full employment. The Fed’s long-term inflation target is around the 2% level. The Fed estimates an unemployment rate of 5.2% to 5.6% as consistent with the full employment level. Maintaining an accommodative monetary policy stance by keeping interest rates low is likely to stimulate private investment in the economy and create jobs. On the other hand, increased money supply in the economy brought on by low interest rates is also likely to create inflationary pressures. So the Fed aims to balance these two goals and decide upon a monetary policy that ensures optimal results for the economy.

How does the Fed’s dual mandate impact financial markets?

Inflation impacts the overall economy. An increase in inflation would raise the nominal interest rates on bonds, reducing their prices, all else equal.  Treasury inflation-protected securities (or TIPS) protect the value of debt securities from eroding due to inflation. They’re issued by the U.S. government, and the par value of these securities increases with inflation. ETFs providing exposure to TIPS include the iShares TIP Bond ETF (TIP).

Inflation will also affect equity ETFs like the Vanguard S&P 500 ETF (VOO). The top ten holdings in VOO include energy majors Exxon Mobil and Chevron as well as consumer packaged goods company Proctor & Gamble (PG) and technology company Microsoft (MSFT). Companies in the basic materials and energy sectors are some of the most immune from inflationary trends in the economy, as they find it easier to pass on cost increases to customers. As the economy improves, PG and MSFT should get a boost. An improvement in the labor market should benefit PG, while businesses are likely to scale up technology investments due to the improving business environment, which is likely to benefit MSFT.

The Fed has maintained its most important monetary policy tool, the Fed funds rate, at near zero levels since December 2008. The Fed has also embarked on three rounds of quantitative easing in a bid to stimulate the economy and create jobs following the 2008 financial crisis and Great Recession. Now that the economy is back on the road to recovery, there has been increasing debate among Fed officials and market participants on if and when to raise the Fed funds rate. Fed hawks would want to raise the base rate sooner rather than later due to inflation concerns, while the doves would want to maintain low rates as long as the labor market doesn’t recover to full employment levels. The consensus range on timing appears to be sometime between Q2 and Q4 2015.

Part 4.1Enlarge Graph

Doves and hawks on the FOMC

Notable hawks on this year’s FOMC include Dr. Charles Plosser and Richard Fisher, heads of the Philadelphia Fed and Dallas Fed, respectively. Fed Chair Janet Yellen is widely viewed as one of the most dovish members of the FOMC. Outgoing Cleveland Fed president and CEO Sandra Pianalto is viewed as a centrist. Loretta Mester’s views on the employment versus inflation debate are particularly relevant, as she will be voting on policy this year.

As we explained in Part 1 of this series, next year, the composition of the FOMC will change again. 2015 is particularly relevant, as most economists predict rate hikes in that year. Presidents Plosser (Philadelphia Fed), Fisher (Dallas Fed), Mester (Cleveland Fed), and Kocherlakota (Minneapolis Fed) will make way for the presidents of the Chicago, Richmond, San Francisco, and Atlanta Federal Reserve Banks. So the composition of the FOMC and the leanings of its members are likely to be important determinants in the timing and level of the base rate.

Fed monetary policy normalization

The Fed also will be looking at ways and means to normalize its $4.3 trillion balance sheet brought on by three rounds of quantitative easing. The views of new members will also influence the process of normalization. A number of Fed officials have spoken on normalization strategies, including the Dallas Fed’s Richard Fisher and the San Francisco Fed’s John Williams.

To read about Richard Fisher’s views on the Fed’s excess reserves, please read the Market Realist article Richard Fisher explains why excess reserves can create velocity.

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