5 Things To Ponder: The Fed

September 28, 2014

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It has been quite an eventful week between Scotland’s battle over independence, the Federal Reserve’s FOMC announcement and the markets making new all-time highs.

For Scotland, the decision came down to the benefits of maintaining their unity with the United Kingdom. While William Wallace may not have agreed, the vote to remain part of the U.K., which cannot happen again for a generation, removed a potential stumbling block for the markets globally.

The FOMC announcement was more comedy than anything else as the continued facade of the Fed’s forecasting capabilities was revealed. However, the reiteration of the Fed’s commitment to “remain accommodative” for as long as necessary gave comfort to traders that while the “punch bowl” was no longer being refilled, it was not being taken away either.

However, one announcement from the Fed that did not get a lot of media attention was their new policy to “reduce” the size of the Fed’s balance sheet. The general plan is as follows:

Determine timing and pace of normalization
Reduce securities holdings and maintain low interest rates
Gradually reduce the reinvestment of principal repayments
Sell mortgage-backed bonds if warranted.
Reduce balance sheet over the longer term to only the size needed to implement policy.

These actions will be taken in conjunction with the Federal Reserve’s attempt to normalize interest rate policy.

Importantly, these combined actions constitute the removal of the “punch bowl.” While I suspect that Janet Yellen truly believes that the economy is strong enough to support such a process, a look at Japan’s failed attempt as creating inflation, boosting economic growth and normalizing policy should give her a clue. This is a topic that I will delve into more deeply next week.

However, for this weekend’s list of “Things To Ponder” I have accumulated a few reads relating to the Fed. As always, it is important to eliminate “confirmation bias” be evaluating decisions based on a complete understanding of the argument.

1) Fed Exit May Be A Bumpy Ride For Investors by Ben Eisen and Greg Robb via MarketWatch

This is a good article and MarketWatch delved into the four key policy tools that many market participants believe will be crucial to the exit, looking at how they will function, the market and policy implications, and what questions remain unanswered.

Interest rates
Reverse repos
Excess reserves
Managing the balance sheet

“The Federal Reserve’s next tightening cycle won’t look like anything investors have seen before.

The central bank has never attempted to hike interest rates with a $4.4 trillion balance sheet. To do so, the Fed is counting on a slew of new instruments — and the liftoff still might not function properly at first.

‘They will be experimenting with new tools. Any time you do that, there are uncertainties and there are risks. We expect them to be able to manage it, but it could be a bumpy ride,’ said Kim Schoenholtz, a professor in New York University’s Stern School of Business.”

2) Fed Prepares To Raise Rates, End Failed QE via Real Clear Markets

“The Federal Reserve said Wednesday the economy isn’t as strong as it believed just two months ago, and that it’s not likely to raise interest rates soon. It’s as close to an admission of failure as you’ll ever get.

As rates rise, big questions remain: Will the higher rates the Fed is engineering sink the economy? Will we see unemployment return to recession levels?

It doesn’t seem likely. And yet, in 2008, if someone had told you that the Census Bureau would report in September 2014 that median income had shrunk 8.2% over the preceding five years, and only those with the highest incomes would see any gains at all, you might have thought that person was crazy.

Well, it happened. Thanks to President Obama’s misbegotten economic policies and “stimulus,” and the Fed’s own radical experiment in money printing, the U.S. has had its worst recovery ever from a recession.

To its credit, perhaps, the Fed is now quietly trying to undo its failed experiment, by letting markets set interest rates and shutting down the QE program. If so, it’s a minor victory for common sense and policy prudence.”

3) Why Fed Bet May End In Disappointment by Mohamed El-Erian via Bloomberg

“The U.S. Federal Reserve is trying to squeeze a bit more out of a stimulus policy that relies heavily on artificially boosting stock and bond markets to generate growth. In doing so, it is running a higher risk of financial instability, and increasing its dependence on a Congress that shows little sign of being able to handle fully its economic responsibilities.”

4) Do The Fed’s Forecasts Get Marked To Market? by Randall Forsyth via Barron’s

“‘Don’t fight the Fed’ is one of the oldest adages on Wall Street. But the financial markets remain at odds with the central bank’s own projections for interest rates.

…the futures market is casting its dissent in the other direction—that the Fed officials are wrong in expecting faster and bigger rate hikes. That would seem to be a reflection of the markets’ recognition that the Fed’s forecasts for economic growth have proved mostly too optimistic.

Thus, the central bank thinks the U.S. economy is on a path for sustainable 3% growth while the futures market thinks it remains in its “New Normal” path around 2%.”

5) The Math Of The “Dot Plot” by James Mackintosh via Financial Times

“[Fed members] all expect rates to start rising next year, and to rise by 175bp by the end of the year. Assuming the Fed sticks to 25bp hikes – although it doesn’t have to, it hasn’t raised rates more than that in a single meeting since May of 2000 – that means raising rates seven times next year.

But with the markets completely hung up on the idea that the phrase ‘considerable time’ in the FOMC statement amounts to a promise not to raise rates for six months – in other words, until April – it is worth considering that five out of the 17 participants appear to expect rates to go up by March.

Janet Yellen, Fed chair, had another go in her press conference today at trying to stop investors assuming that ‘considerable time’ means six months, saying there is no ‘mechanical interpretation’ of what it means – but if investors keep thinking it is six months, from the October end of QE, that means the first rate rise won’t come before April. The dots suggest there will be lots of pressure within the FOMC for a rise before that. Bond markets should wake up to the risk.”