Must-know: St. Louis Fed’s Bullard on the earlier rates increase

Phalguni Soni

Overview: Will the Fed's doves and hawks find common ground? (Part 3 of 11)

(Continued from Part 2)

Why the rates will increase earlier than expected

James Bullard has been head of the Federal Reserve Bank of St. Louis since 2008. Widely regarded as a centrist, he believes the Fed should adopt “state-contingent policy,” which is policy that is adjusted based on the state of the economy. He has supported quantitative easing (or QE) in the wake of the financial crisis. As head of the St. Louis Fed, he will be voting on policy decisions at the Federal Open Market Committee (or FOMC) in 2016.

In this section, we’ll discuss his views on monetary policy and why he thinks a rate increase could come earlier than many market participants expect.

On the Fed’s twin mandate

In a presentation to the  Tennessee Bankers’ Association on June 9 , Dr. Bullard said that the Fed faced a classic monetary policy challenge. He said, “With inflation still below target, albeit rising, and unemployment still high, but falling, the Committee faces a classic monetary policy challenge. The challenge is this: How quickly should the Committee move to return monetary policy to normal given improving macroeconomic conditions?”

In a video interview with Maria Bartiromo on Fox News on June 29, Dr. Bullard clarified his stance on monetary policy and the outlook for economic growth.

On the path of the Fed funds rate

In the interview, Dr. Bullard remarked that financial markets didn’t realize how close the FOMC was to achieving the Fed’s twin mandate of full employment and inflation around the 2% level. He believes that by the second half of 2014, the unemployment rate could be “very close to normal” and the inflation rate would approach the Fed’s 2% target rate.

Dr. Bullard said he was a little ahead of the FOMC in terms of raising the Fed funds rate, as he expects an increase by the end of 1Q15. He also commented that he believed the normal long-term (five to ten years from now) level of the base rate would fall in the range of 4%–4.25%.

On the normalization of monetary policy

Dr. Bullard remarked that a lot of Treasury securities were maturing. As a way to normalize the Fed’s balance sheet, he recommended that the Fed could simply let those mature and not replace them. This would represent a “benign way” to reduce the size of the Fed’s $4 trillion plus balance sheet.

Economy to grow at over 3% between 2Q14–4Q14

Describing the 2.9% decline in Q1 gross domestic product (or GDP) as a “shockingly negative number” the sharp downwards revision was mostly a weather-related “aberration” according to Dr. Bullard. He expects GDP growth of above 3% for the remainder of the year and into next year, citing strength in the tech, agriculture, financials, and manufacturing and energy sectors.

Investor impact

Based on improvements in the labor market and manufacturing, the S&P 500 Index (SPY) has touched record highs several times this year. The Technology Select Sector SPDR ETF (XLK) has returned 6.28% this year compared to 4.79% for the SPDR S&P 500 ETF (SPY). XLK has a three-year average beta of 0.75 compared to one for the S&P 500 Index (Source: Yahoo finance; Market returns through May 31).

A faster-than-expected rate increase would likely impact yields across the board in fixed income markets (AGG), impacting both Treasuries (TLT) and high-yield debt (HYG).

In the next section, we’ll discuss Philadelphia Fed Chief, Charles Plosser’s views on monetary policy. Please continue reading the next section in this series.

 

Continue to Part 4

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