Kansas City Fed President—why the headwinds won’t last too long

Market Realist

Kansas City Fed President on economic and monetary policy outlook (Part 5 of 5)

(Continued from Part 4)

Slower recovery

Ms. George, the Kansas City Fed president, talked primarily about the following two headwinds while explaining that the economic recovery has been slower than normal:

  1. Tight credit conditions
  2. Uncertain and restrictive fiscal policy

 

 

1. Tight credit conditions

Although eased since the end of recession, credit conditions have remained tight. Consumer borrowing has stepped-up recently while growth in other types of credit, such as leveraged lending and sub-prime auto loans, remains a concern.

2. Uncertain and restrictive fiscal policy

While last year’s tax increases and cut in government spending affected growth in 2013, the effect of fiscal restraint is abating. As a result, Ms. George feels that the fiscal policy might not be a problem for future economic growth.

In Ms. George’s view, the Fed funds rate should be raised sooner than projected and at a faster pace to disincentivize markets and investors to take risks in an economy already operating at a full capacity.

If interest rates are kept low in an economy operating at full capacity, investors may take leveraged bets on equities (VOO). A low interest rate in an economy operating at a full capacity will drive the inflation higher, driving the bond prices (BND) down as the future value of today’s dollar in the future diminishes with rise in inflation. Within bonds, Treasuries (TLT) will be affected the most followed by investment grade bonds (LQD) and high-yield bonds (HYG). The leveraged bets on equities could lead to another financial crisis if markets fall sharply.

Why clear monetary policy communication is important, according to Ms. George

As the economy continues to recover, monetary policy must be revised to let go of the extraordinary stimulus it has offered over the past five years. Gradual normalization and clear communication are the key considerations to ensure a smooth reaction from the markets. The normalization will help markets play a greater role in resource allocation and will help investors price risks appropriately.

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