Asset Management

Translating the Fed’s “English” lesson

Timothy Hopper, Chief Economist

December 12, 2013

Click here for a downloadable version (PDF)

The Federal Reserve has kept interest rates historically low for several years both through traditional monetary policy tools, such as keeping the federal funds rate near zero, and through more non-traditional tools such as outright purchases of government and mortgage backed securities (called quantitative easing). These policies and programs are aimed at stabilizing the U.S. economy while also addressing its dual mandate of achieving maximum employment and stable prices. As this loose policy stance enters its sixth year of existence, investors have begun looking for signs that the Fed will change its view. In effect, investors are looking to the time where interest rates will rise again.

Article Highlights

  • A recent white paper authored by Federal Reserve staff members provides insight into the central bank’s thinking on monetary policy.
  • The paper suggests the Federal Reserve is likely to remain cautious when it comes to tapering its quantitative easing program and will likely avoid raising short term interest rates for at least a couple more years.
  • Traditionally tight-lipped, the Fed has become more open about internal policy debates under Chairman Bernanke’s tenure.

A recent white paper   from Fed staffer William English and others sheds some light on this thinking, which provides investors an unusual look at a behind-the-scenes debate within the central bank. The paper suggests, for example, that the Fed could consider waiting until unemployment is a full percentage point lower than the Fed’s current threshold of 6.5% before considering taking action on interest rates. The “threshold” is not a hard target, but a signpost that would likely trigger the beginning of a discussion on increasing interest rates. The paper suggests that the threshold should be lowered because the current economic recovery has taken longer than usual and continues to be uneven.

Nothing in the paper changes our view that QE3 tapering could occur most likely by March, or that any hike to the key federal funds rate remains years away, though it provided interesting insight into how the central bank views these issues.

A soft employment threshold and lower rates for longer

The paper suggests to us that the Fed’s current unemployment threshold is “soft” which means it will approach any changes to policy with extreme caution and likely wait for further economic recovery before deciding to raise rates. This means the Fed is therefore unlikely to discuss moving the federal funds rate before the unemployment rate reaches a range between 5.5-6%. The statistical models in the paper suggest this could happen in the 2016-17 timeframe.

Exhibit 1: Federal funds target rate
Exhibit 1Quantitative easing

While there was only a short discussion about QE3 in this paper, the authors mentioned that it is too early to tell whether the Fed’s open-ended and unlimited bond purchase program has been effective. The difference between the latest program and its predecessors is that QE3 is not limited to a timeframe or amount of purchases, which means the potential costs could be larger. The Fed has purchased roughly $4 trillion in bonds on the open market since 2008, with the effects on the overall economy still being debated. The Fed initially intended QE to drive consumer credit growth, though this largely has not happened. While failing to jumpstart consumer spending, QE may have kept deflation at bay, and also may have stabilized the financial system in the aftermath of the 2008-09 crisis. While the effects of QE will be debated for years to come, the authors of the paper indicate that even the Fed isn’t sure what to make of it.

More communication in 2014

We expect that the Fed will continue to follow its current course in 2014, as it transitions to new leadership. Janet Yellen, President Obama’s nomination to succeed outgoing Fed Chairman Ben Bernanke, is one of the architects of the current policy. Yellen will likely continue to follow the same course the Fed is now on, which is one of caution and restraint especially as the U.S. economic recovery remains stuck in low gear and spotty. An untimely rise in interest rates could slow the entire economy, which is what happened when rates rose sharply between May and July. The increase led to a slowdown in housing activity, and caused employment growth and private sector investment to stop cold. Partly because of this episode, we believe the Federal Reserve will keep QE in place until the economy shows considerably stronger positive momentum.


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