Macroeconomic and monetary policy outlook
Esther L. George, the Kansas City Fed president, started her commentary about macroeconomic and monetary policy outlook by saying that increasing rates in an improving economy is much more difficult than cutting rates in a slowing economy. “This is especially true if the signals of sustainable growth are not entirely clear cut,” she added.
While the massive bond buying program was an aggressive step taken by the Fed to stimulate the economy, the normalization and tightening process could be much more complicated. As a result, sending the appropriate signals to markets and communication will be the most important aspect of the monetary policy actions. To read ex-member of the Fed’s board of governors, Jeremy Stein’s speech on monetary policy communication, click here. For example, when the Fed hinted at “tapering” the asset purchase program for the first time in June, 2013, the bond yields increased sharply because the markets took it as a hint towards earlier-than-expected monetary tightening.
If the pace and magnitude of the rate hike is higher than what the market anticipates, it may lead to a fall across the bond market (BND), especially the Treasuries (TLT), and to investment grade bonds (LQD), high-yield bonds (HYG), and mortgage-backed-securities (MBB).
The economy is gradually getting back on track with inflation increasing (inflation for May was 1.6%) towards the Fed’s 2% target. Also, unemployment is now less than 1% from the Fed’s target full employment levels. However, the monetary policy normalization still needs to improve. In its projections, the Fed expects the Fed funds rate to remain lower than the long-term average at the end of 2016. However, Ms. George expects the tightening to happen earlier than the Fed’s projected date.
Ms. George went on to talk about the headwinds and their impact on monetary policy. Continue reading the next section of this series.