Potential changes to the Fed’s forward guidance and monetary policy

The Cleveland Fed’s Loretta Mester speaks on the economy and monetary policy in Pittsburgh

Financial markets are keenly watching for signs of when the Fed plans to raise rates. The Fed’s communication is hugely important. Analysts and economists examine it in great detail for hints of the Fed’s policy.

Cleveland Fed chief Dr. Loretta Mester—along with vice-chairman of the Board of Governors, Dr. Stanley Fischer, Governor Jeremy Powell, and San Francisco Fed chief John Williams—has been asked by Fed Chair Janet Yellen to serve on a communications subcommittee to help the FOMC frame and organize the Fed’s communication on a broad range of monetary policy issues.

“The communication surrounding normalization is going to play an important part in how well the journey goes. Explaining the factors that influence the changes in the outlook and FOMC policy decisions, as well as how the FOMC plans to conduct policy, can help the public make informed expectations as the economy evolves and monetary policy travels back to normal,” said Dr. Mester, speaking at an event jointly hosted by the Economic Club of Pittsburgh, CFA Society Pittsburgh, and the Pittsburgh Society of Investment Professionals on September 4.

Potential changes to the Fed’s forward guidance and monetary policy

A rate rise affects your bond investments, as rate increases translate across bond markets. Bond prices fall when rates increase and vice versa. A rise also affects returns on stocks (DIA)(SPY) and real estate investments. Companies like General Electric (GE) and Wal-Mart (WMT) would need to pay a higher interest rate on any new debt issues.

Mortgage rates also follow movements in Treasury yields. An increase in mortgage rates would affect the real estate market (IYR).

Recent developments in the Fed’s forward guidance on monetary policy

  • Earlier, the Fed had maintained a quantitative unemployment target of 6.5% before the Fed funds rate could increase. The Fed removed the target in March, as it reached the unemployment goal faster than expected.
  • The Fed also changed its guidance policy from quantitative to qualitative.
  • The Fed has said that it would maintain the 0%–0.025% range for the Fed funds rate for a “considerable period” after asset purchases end.

With the end of the taper approaching, Mester feels the Fed needs to “reformulate” its forward guidance policy to markets. This would reduce “undesirable disruptions and turbulence” in financial markets as policy normalization approaches.

“My preference is for forward guidance to convey that changes in the stance of policy will be calibrated to the economy’s actual progress and anticipated progress toward our dual-mandate goals, and to the speed with which that progress is being achieved… A faster pace of progress toward our goals would argue for a faster return to normal, while a more subdued pace would argue for a slower return,” she said.

As you saw earlier in this series, interest rate increases have major implications for bond markets. To learn about recent trends in the U.S. investment-grade bond market, please read the Market Realist series Overview: Investment-grade bond ETFs.