The FOMC, the Fed’s monetary policy unit, meets next week on January 28th and 29th. It will be Ben Bernanke’s last meeting and the beginning of Janet Yellen’s leadership of the central bank. No immediate change in Fed policy is likely – winding down QE3 over the next few months as announced in December will continue, the Fed funds rate target won’t shift from its current zero to 25 basis points and the yield on the ten year Treasury note won’t rise by much.
While there won’t be an immediate shift, the membership of the FOMC will change and a review of the economic outlook and monetary policy is likely at this meeting. The changes to the FOMC include the usual rotation of the four representatives from among 11 of the 12 regional banks as well as two recently nominated members of the Fed Board of Governors.
What will the new year and new members bring?
Tapering and the end of QE3 are expected in 2014. The quantitative easing programs were successful in lowering intermediate and long term interest rates and boosting the stock and housing markets. However, with the economy better off than it was a few years ago and questions heard about the additional benefits of further bond buying, this effort is likely to fade away. Despite fears voiced by some, the program did not create inflation. In fact, inflation at about 1.5% is below the Fed’s target and deflation is seen by some analysts as a larger worry for 2014.
With the end of QE1-2-3, the Fed’s policy making tools will focus on interest rates, forward guidance or announcements of future policy and possibly some of the Fed’s banking regulations. The target for the Fed funds rate is likely to stay at zero to 25 basis points well into 2015 if not longer. This will keep a lid on the yield on the ten year Treasury note, even if economic growth exceeds expectations. The ten year yield can be thought as the average of the ten successive one year returns. With assurances that the one year returns won’t rise much in the next two or three years, the longer 10 year number is likely to be somewhat contained.
Jawboning – as forward guidance used to be called – is both powerful and hazardous. For investors and traders, ignoring the Fed is always a risky policy. So, forward guidance of lower interest rates will encourage a rapid market response to bring rates down towards the Fed’s desired levels. But the Fed is not clairvoyant when it comes to predicting the economy or future policy needs. Sooner or later there will be a moment when the central bank will need to change its forward guidance, change from lower interest rates to higher interest rates. In the days when watching the Fed was “watch what they do, not what they say,” a policy reversal was accepted, maybe even expected. But if forward guidance is cancelled and reversed, investors are likely to doubt or even ignore future forward guidance. For now announcing intentions works, but for how long no one knows.
Currently the Fed pays interest on the reserves banks hold at the Fed. Excess reserves – funds greater than the required level of banks’ reserves – rose sharply during the financial crisis when the Fed began to pay interest on reserves. Whether or to what extent the Fed can influence banks’ reserve positions through the interest rate it pays remains to be seen. However, this is one area that the Fed may look to if the needs of monetary policy shift.
Expect a new economic forecast from the upcoming FOMC meeting. If it is as optimistic as the last one or more so, say goodbye to QE123, expect more focus on the Fed funds rate and a little less interest in forward guidance. The transparency that Ben Bernanke brought won’t change.