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How the Fed’s monetary policy is still linked to economic recovery

Phalguni Soni

Charles Evans explains the Fed's need to keep the base rate low until 2016 (Part 3 of 7)

(Continued from Part 2)

GDP growth needs to be more sustainable

Charles Evans spoke at the Asian Investment Conference in Hong Kong on Thursday, March 27. In his speech, he discussed accommodative monetary policy, inflation, and financial stability. He argued extensively in support of an accommodative monetary policy stance.

Although GDP grew at a little under 3.5% in the second half of 2013, up from an average rate of 2% in the past three years, inflation remains at ~1% level, well above the Fed’s long-term target of 2%. GDP growth will also be adversely affected in Q1 2014 due to the harsh weather brought on by the polar vortex. Charles said that “economic activity abroad is not robust” and “fiscal policy is a restraint on economic growth.” While these headwinds appear to be dissipating, risks and resource gaps remain for which monetary policy still needs to be accommodative.

Ideal unemployment target to be at the 5.25% level

In support of his argument for an accommodative monetary policy, Charles also said that the unemployment rate, which has dropped from 8.1% in September 2012, when the QE3 and monthly asset purchases began, to 6.7% in February 2014, still remains above 5.25%. He thinks it will prevail over the long-run.

On why the Fed updated its guidance at the March FOMC

Charles stated that given these developments in GDP growth and unemployment, the Fed decided to reduce its monthly asset purchases of longer-term Treasuries (TLH) and agency-backed securities (VMBS) from $85 billion per month in the beginning of December to $55 billion currently, by announcing a reduction of $10 billion in each of its FOMC meetings held in December, January, and March.

The policy statement after the March FOMC meeting now mentions, “when deciding how long short-term rates will remain at their current level, the Committee will use a wide range of information to assess the realized and expected progress toward our dual mandate goals of maximum employment and price stability.” The statement also indicates that given the Committee’s current assessment of these factors, it likely will be appropriate to keep the Fed funds rate at its current level for a considerable period after the asset purchase program ends. Furthermore, even after the economy lifts off and employment and inflation are near mandate-consistent levels, economic conditions likely will warrant keeping short-term rates below the typical long-run level rates for some time.

Implications for investors

Since bond prices rise when interest rates fall and vice-versa, stable interest rates at least over the short-term, can keep rates low at the short end of the yield curve. However, due to the Fed gradually reducing purchases for fixed income securities like longer-term Treasuries (TLT) and agency-backed securities (VMBS), this may impact demand for these securities and impact their prices. Bond prices move inversely to interest rates. One way of profiting from falling bond prices and rising interest rates is to invest in inverse bond funds like the ProShares Short 20+ Year Treasury Fund (TBF) and the Barclays iPath US Treasury 10-Year Bear ETN (DTYS). Inverse bond ETFs provide the inverse return of the underlying benchmark index.

Read about what Charles Evans had to say about the Fed’s second mandate, inflation, and why it is critical for the U.S. economy in Part 4.

Continue to Part 4

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