Charles Evans sheds light on the Fed's long-run monetary policy (Part 2 of 4)
The Fed’s dual mandate
The Fed’s dual mandate is balancing inflation with unemployment—that is, achieving both maximum employment and price stability. In order to meet both these long-term objectives, the Fed needs to balance the effect of a monetary move on both inflation and changes in unemployment.
However, achieving this balance has been difficult to achieve in the past due to the following constraints.
Deleveraging in the aftermath of the financial crises
“Deleveraging” refers to the reduction of the percentage of debt (or leverage) in the balance sheet of an economic entity. The financial crisis of 2008 led the U.S. economy into a high leverage situation. So the economy needs to deleverage its debt burden, which seems to constrain the achievement of policy targets.
Global risks, such as that posed by the European debt situation, impart substantial downside to the achievement of monetary policy objectives. Events that affect the cost and availability of credit negatively affect growth in U.S.
Unusually restrictive fiscal policy
As evidenced by the Fed’s tapering initiatives, the government is trimming its spending on massive bond purchases. However, a cut in government spending usually leads to lowering inflation rates in the economy. With the current inflation rate lower than even the target inflation rate of 2%, the Fed’s restrictive fiscal policy seems quite unclear in its objective.
Monetary policy constrained by a zero lower bound
A “zero lower-bound” refers to a situation in which the short-term nominal interest rate is zero, or just above zero, causing a liquidity trap and limiting the capacity that the central bank has to stimulate economic growth. The current Fed funds rate is zero-lower-bound, on account of the quantitative easing measures taken by the Fed. Though such large-scale asset purchases have considerable effects on reducing the long-term interest rates on U.S. Treasury debt and mortgages, there remains a great deal of uncertainty about the magnitude of these effects and their impact on the overall economy.
A fluctuation in rates exposes investors in Treasury securities to interest rate risk. These risks can be hedged by investing in inverse Treasury ETFs like the ProShares Short 20+ Year Treasury (TBF) and the iPath US Treasury 10-year Bear ETN (DTYS). To learn more about hedging strategies, read the Market Realist series Hedging your portfolio: Simple strategies and outstanding benefits. Besides Treasuries, ETFs like the ProShares Investment Grade-Interest Rate Hedged ETF (IGHG), which has its major holdings in companies like Citigroup Inc. (C) and JP Morgan Chase & Co. (JPM), and the PowerShares Senior Loan Fund (BKLN), also protect against interest rate risk.
Browse this series on Market Realist:
- Part 1 - Charles Evans sheds light on the Fed’s long-run monetary policy
- Part 3 - Why a zero lower bound is constraining the Fed funds rate
- Part 4 - The path ahead: Toward the end of large-scale asset purchases
- Budget, Tax & Economy