Is qualitative forward guidance better than no guidance at all?

Market Realist

The Dallas Fed's Richard Fisher shares key forward guidance (Part 2 of 10)

(Continued from Part 1)

The March FOMC

At the recently concluded Federal Open Market Committee (or FOMC) meeting of the U.S. Federal Reserve, the Fed said it would remove the quantitative thresholds from its policy statement that would guide markets on when the Fed would raise its base rate (or Fed funds rate).

How does the Fed’s forward guidance affect investors?

As per the U.S. Federal Reserve: “Through ‘forward guidance,’ the Federal Open Market Committee provides an indication to households, businesses, and investors about the stance of monetary policy expected to prevail in the future. By providing information about how long the Committee expects to keep the target for the federal funds rate exceptionally low, the forward guidance language can put downward pressure on longer-term interest rates and thereby lower the cost of credit for households and businesses, and also help improve broader financial conditions.”

The Fed will shun quantitative thresholds in its forward guidance

Since last year, the Fed had defined an unemployment level of 6.5% and a long-term inflation goal of 2% as essential before considering an increase in the Fed funds rate. However, due to the unemployment rate falling faster than policymakers had anticipated (due to discouraged workers exiting the workforce altogether) and inflation remaining stubbornly below the 2% threshold, the Fed decided to revise its forward guidance that it provided markets from quantitative to qualitative.

At the March 2014 meeting, the Fed indicated that, in determining how long to maintain the current 0% to 0.25% target range for the federal funds rate, it will assess progress—both realized and expected—toward its dual mandate of full employment and 2% inflation. This means that it would no longer provide numerical thresholds, but instead take “into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.”

The Fed funds rate has remained in the range 0% to 0.25% since December 2008. At this month’s FOMC meeting, members of the FOMC provided individual forecasts on when they expected the Fed Funds rate to rise and by how many basis points (or bps). Fourteen of the 16 FOMC members estimated a rate hike by 2015. Fed officials also revised their forecast for the median rate at the end of 2015 to 1% from 0.75%.

How can investors profit from the coming rate hike?

A change in the Fed funds rate would impact both stock markets and fixed income markets. Other things remaining constant, an increase in the Fed funds rate would imply that the economic growth is on track, which should boost stock market returns. One ETF with exposure to a broad-based index like the S&P 500 Index is the Vanguard S&P 500 ETF (VOO). The top ten holdings in VOO include Exxon Mobil Corp. (XOM).

Rate increases would also impact fixed income ETFs, as bond prices fall when rates increase. Investors can mitigate this interest rate risk by investing in floating-rate fixed income ETFs like the Market Vectors Investment Grade Floating Rate ETF (FLTR) and the SPDR Barclays Cap Investment Grade Floating Rate ETF (FLRN). Inverse bond funds like the ProShares Short 7-10 Year Treasury Fund (TBX) and the Barclays iPath US Treasury 10-Year Bear ETN (DTYS) are also a good option. Inverse bond ETFs provide the inverse return of the underlying benchmark index.

To read about what Dallas Fed President Richard Fisher had to say on the market reaction to the Fed funds rate estimates, continue to Part 3 of this series.

Continue to Part 3

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