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The Fed uses 2 newer tools in the unprecedented stimulus territory

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Nov. 26 2019, Updated 2:44 p.m. ET

On the role of forward guidance

Janet Yellen spoke on monetary policy and economic recovery at The Economic Club of New York on Wednesday, April 16. In the last part, we discussed the third of Janet Yellen’s “three broad questions”: What factors may push economic recovery off the track? In this part, we will discuss her take on the monetary policy challenges, the role of qualitative and quantitative forward guidance since the Great Recession, and the recovery.

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According to Yellen, if monetary policy decisions were made in a systematic manner and communicated to the general public, this would avert sharp market reactions to FOMC policy statements. “Monetary policy will thus have an “automatic stabilizer” effect that operates through private-sector expectations,” she said. However, this would also imply that the Fed funds rate would change in response to changes in the economy making its path much more uncertain, but more effective in dealing with the Fed’s twin mandate of inflation and unemployment.

On the current limitations of the Fed funds rate

Due to the base rate stuck at 0% to 0.25% since December 2008, the Fed cannot lower this any further to stimulate recovery. Hence, it started making open market purchases at the rate of $85 billion per month, which currently stand at $55 billion per month.

Forward guidance: From general to specific and back to general

Communicating the Fed’s decisions and their rationale in setting monetary policy is critical during this period. Initially, in December 2008, the Fed said it would maintain the base rate at near zero levels for “some time.” Yellen said that “some time” became “an extended period,” which was later changed to “mid-2013,” then “late 2014,” then “mid-2015.” While the Fed’s goal posts were clear, the rationale behind them was not.

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In December 2012, the Fed further clarified that the Fed funds rate would stay low, at least until unemployment rate reached 6.5% and inflation expectations over the next 1-2 years were no more than 2% to 2.5%. At that time, it was anticipated the 6.5% rate might take 2.5 years to achieve. These numbers the FOMC had emphasized, were not numerical triggers for raising the base rate, which would be increased based on a wide range of indicators.

To learn more, read the Dallas Fed President and CEO, Richard Fisher’s take on future forward guidance in the Market Realist series, Will forward guidance after the taper ends be Odyssean or Delphic?

However, as explained earlier, the unemployment rate fell faster than policy-makers had expected, primarily due to discouraged workers giving up on their job hunt, which lowered the labor force participation rate. The unemployment rate stood at 6.5% in March 2014, down from 7.7% in December 2012.

In the next part, we will discuss the forward guidance policy with respect to the pace of asset purchases. In the coming sections, we will also assess the impact of the increase in the base rate on inverse bond ETFs like the ProShares Short 7-10 Year Treasury Fund (TBX) and the Barclays iPath U.S. Treasury 10-Year Bear ETN (DTYS), and floating rate funds like VanEck Vectors Investment Grade Floating Rate ETF (FLTR) and the iShares Floating Rate Bond (FLOT). We will also assess the impact of interest rate increases on cyclical stocks (XLY).

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