Fed Policy Options Predictable but Limited

Fed Policy Options Predictable but Limited

While the Federal Open Market Committee is not expected to change short-term interest rates when it meets next week, investors will scrutinize its announcement for hints about when in 2016 it will raise them. 

Federal Open Market Committee Meeting |
Federal Open Market Committee Meeting | Federal Reserve (CC 2.0)

In a period (or should we say era?) in which the Fed has kept rates near zero through both recession and recovery, their main way to influence the markets has been through what is called “forward guidance”: the Fed’s assessment of the economy and hints about what it might do next time. (Or the time after that.)

Where US presidents have a bully pulpit, the Fed has forward guidance: a way to assert authority over the markets simply by what it says. After so many years of using only forward guidance and, except for last December, no interest rate changes, the Fed may be close to the limits of what its current tools can do.

Why? When the Fed drops hints about its intentions for the next few quarters, it doesn’t have much effect on the long end of the yield curve, even though it hopes to. A bank won’t adjust its 30-year mortgage terms based on what Janet Yellen says she might do in September.

What could the Fed do to affect 10-year notes and 30-year bonds? If the Fed were to swap out hundreds of billions of dollars in short-term assets for those longer-term instruments and make a substantial change to its balance sheet, that would send a clear signal.

So far, the Fed has not put its money where its mouth is by doing that. Balance sheet adjustment would be a powerful new tool which the Fed could apply in a gradual fashion. Some FOMC members have argued that it could proceed even through shocks like Brexit.

The Fed uses asset adjustments already. Before any interest rate increase, the Federal Reserve banks typically prepare the banking system by lowering reserve balances. It did so in 2015 ahead of the December rate increase. After the increase, the Fed released further reserves to keep the effective rate at 37 basis points, right in the middle of the 25 to 50 basis point range it had targeted.

After that, the Fed increased reserve balances by $130 billion through March, but then began releasing reserves again. For many Fed watchers, that lowering of reserve balances was a sign that the Fed was planning another rate increase in summer.

Then Brexit happened. In the aftermath, the effective Fed Funds rate has crept up from 37 points to 40, which seems minor except for the timing and the fact that the Fed is not adjusting its reserves to push it back down.

While the Fed may have delayed raising rates because of Brexit, more of its members and observers are arguing for another rate hike in 2016, mainly because the US economy looks too strong not to. The low May jobs number was troubling, but with weekly jobless claims continuing to be low and June’s number exceeding the most positive expectations, the trend seems to still be positive.

Investors seem to agree. The large flow of cash away from UK and EU assets and into the US, even into US Treasuries with record low yields, suggests that investors still find US assets the safer option. That optimism about the US economy is why the Fed doesn’t want to cause trouble either by acting too soon or by failing to act.

The Fed’s conundrum comes in part because it has restricted itself to those two basic tools: short-term interest rates and forward guidance. If it added balance sheet adjustment, it could directly manipulate the yield curve and potentially make it easier for banks to lend without driving up the cost to the end borrower.

The US economy is strong and not raising the Fed Funds rate soon could lead to problems down the line. If inflation or wages go up in the next couple of years, the Fed will need to be nimble. A rise in the Federal minimum wage is likely if the Democrats win in November.

Nimble means being able to buy back bonds from the open market or sell them into the market at a pace that doesn’t disrupt. The actual implementation of monetary policy is a coordinated dance between the network of Federal Reserve depositories, large banks, and the ancillary banks, insurers, and other institutions who do business through the big ones.

Implementing changes in monetary policy isn’t so much like turning a supertanker, as getting a flotilla of supertankers to move in coordination to spell out “0.50%” without sinking each other. The more tools the Fed has to work with, the more nimble it can be.

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