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Federal Reserve Chair Janet Yellen travels to Washington this week to testify on the US central bank’s Semi-annual Monetary Policy Report. She will appear before the House Financial Services Committee tomorrow afternoon and then before the Senate Banking Committee on Thursday. Dr Yellen’s prepared remarks are released ahead of tomorrow’s testimony and then repeated to the Senate committee the following day, so her delivery of the actual testimony isn’t that important. But policymakers question her on both occasions and this opens up the possibility of an unguarded remark leading to an insight into the Fed’s current thinking.

Of course, Dr Yellen is now a seasoned performer so the chance of her revealing some choice tradable nugget is low. In addition, the Fed Chair has gained the reputation of being almost of an equal to her predecessor Alan Greenspan when it comes to obfuscation. This is a shame as it’s really the job of all central bankers to offer up clear signals to the markets to help business owners and investors prepare for changes in monetary policy. Yet it’s certainly the case that the Fed hasn’t got the greatest track record when it comes to signposting its intentions. We only have to go back to February this year to remember how a succession of regional Fed presidents and FOMC members rushed out to convert a 20% probability of a March rate hike into an 80% chance in a matter of days.

Going back further, we’ve had years of “caution” from the Fed with only one 25 basis point rate hike throughout Obama’s presidency; plus the end of quantitative easing. Yet the central bank has tightened by 75 basis points since Trump became president and is preparing the markets for more. It will be interesting to see if policymakers will question Dr Yellen about this sudden volte face and if she will respond.

But that aside, the questions for investors are: what are the Fed’s plans when it comes to additional monetary tightening, and what could persuade it to alter course? Going by the Fed’s statement, summary of economic projections and minutes from the June meeting, it seems clear the central bank is on a mission to “normalise” rates and reduce its balance sheet. The Fed forecasts another 25 basis point rate hike before year-end and also intends to start winding down its $4.5 trillion balance sheet. On top of this it expects to raise rates by an additional 75 basis points throughout 2018 together with a gentle (maybe $10 billion per month) in balance sheet reduction. By contrast, the market expects just 50 basis points of rate hikes between now and the end of next year and a cautious slowdown in balance sheet reinvestment. Why the discrepancy between the two sides? Well for one, over the past four years or so the Fed has repeatedly prepared the market for rate hikes which never came. Secondly, many analysts are concerned that the US economic recovery isn’t as robust as the Fed believes and that inflation is trending downwards rather than heading towards the Fed’s 2% target. Ultimately the central bank will be in no position to tighten so aggressively.

But there’s a school of thought that says the Fed knows it has missed a number of opportunities to raise rates and it’s now playing catch-up. It needs to push rates higher from here so it has room to cut when the next recession comes. Consequently, the attitude in the Fed has changed fundamentally and we can now expect it to tighten monetary policy slowly but steadily unless inflation plummets, unemployment soars or the stock market has an unruly correction. Otherwise we should expect a fed funds rate of around 3% with the balance sheet down to $2.5 trillion. If this analysis is correct, it now seems likely that the Fed will use every opportunity to make this clear.

Disclaimer:

Spread Co is an execution only service provider. The material on this page is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by Spread Co Ltd or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

 

Posted by David Morrison

Tagged: Bulletin PM

Category: PM Bulletin


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