In their meeting that just concluded, the FOMC formally ended ‘the taper’ effective this coming month-end, closing a chapter of multiple quantitative easing programs totaling $3 trillion. This was widely anticipated, though, so markets didn’t react too strongly to the announcement (although some probably would have enjoyed an extension, as hinted about/hoped by a lone committee member last week).
No other policy was changed and language was consistent with prior meetings (elaborated on below)—including keeping the controversial low rates for a ‘considerable time’ reference—although it did appear a bit less aggressively accommodative than before. The key Fed mandate issues we feel are most pertinent continued to show improvement, but at a tempered pace.
Economic growth: The FOMC’s use of ‘modest to moderate’ was in keeping with prior meetings and lack of strong catalysts in either direction.
- While measures like the ISM and consumer/business confidence continue to show positive readings, housing stats have been mixed, which concerns members as the segment has traditionally served as a bigger lynchpin of economic recoveries (housing and its related industries comprise just short of a fifth of GDP). Demographic shifts and a role as the epicenter of the financial crisis may partially explain why it isn’t.
- Global growth outside the U.S. has also been under pressure. While the Fed’s mandate is as a U.S. central bank, not a global one, policy is indirectly affected by and will affect conditions elsewhere. Key areas of interest here are Europe and China.
Inflation: The Fed’s target is a PCE rate of 2%, which translates to slightly more than 2% in CPI terms. The most recent year-over-year readings are 1.5% for PCE and 1.7% for CPI, so we are obviously not there yet, and much of the non-core inflation impact from the past year is from housing/rents. The recent strength of the dollar has served to push imported inflation lower, not to mention the downward impact on prices of crude oil and other commodities.
Employment: This second portion of the Fed’s mandate has been more troublesome for them up through this point. Although the headline unemployment rate has declined to under 6%, other metrics continue to show a bit of slack, particularly in the areas of matching job skills to openings and wage growth. The Fed, particularly with Janet Yellen having a special focus on labor, would like to see better. This has improved dramatically from recessionary lows, however, and that’s often overlooked. The debate continues as to whether marginal weakness is due to cyclical factors (severity/depth of the recession carrying over into an extended and slower recovery) or structural (more serious—implying a skills mismatch, permanent erosion of certain jobs due to technological changes and demographic factors, such as retiring baby boomers).
If not for the 1977 addition of the second employment mandate, rates may have already started to normalize by now, but perhaps still slowly, as the economic growth component remains at a lower trend pace versus other recoveries over the past several decades. Interestingly, there are some observers (including current/former FOMC members) interested in a more philosophically-limited central bank—tasked with an ‘old school’ primary mandate of safeguarding the dollar’s long-term purchasing power and little else, and using quant rules for keeping interest rates in proper check. The modern Fed has obviously evolved far beyond this basic function since its 1913 inception.
Who’s going to buy Treasuries and MBS now that the Fed isn’t? They are still reinvesting proceeds of the small amounts of maturing debt, so technically, they’re still involved. (There’s debate about how long this practice will go on—it may or may not continue based on when the first rate hike occurs, as it does offer the Fed flexibility and an additional cushion for influence.) Other than that, markets will have to absorb it. It’s important to remember, though, that bonds, like any asset, are supply/demand-driven and issuance of new debt has dropped as well (due to a lower Federal deficit and stronger post-recession tax receipts), so both supply and demand are declining from a fundamental basis.
Outlook: GDP for the 3rd and 4th quarters is expected to be in the 3.0-3.5% range. While the stronger dollar may cause some weakness in exports, the dollar’s change versus the currencies of major trading partners (e.g. Mexico and Canada) has been more tempered. Lower oil prices have put a damper on energy companies’ profits and perhaps, if the situation persists, could lessen the interest in energy infrastructure build-out; but they have already been, and could continue to be, a boost to consumers.
Portfolios: By consensus estimate, the key Fed Funds rate is expected to rise by mid-2015 (give or take a few meetings, based on conditions—Fed Funds futures don’t show a conclusive trend either way until Oct. 2015). A smoother rise would be more acceptable to asset markets, which don’t like surprises, while sharply higher economic growth and/or inflation prints could pose a rate shock. Expect Fed language to remain tempered to keep the possibility of such shocks in check. Naturally, short-term rate surprises would affect traditional fixed income portfolios quite dramatically, as investors have paid quite dearly for the low rate ‘insurance’ of low-credit risk government bond portfolios in recent years. Any shocks can certainly generate volatility, but this has to be kept in perspective, as the cause of the volatility is more important. If rates rise due to stronger economic conditions, that may turn out to be a positive longer-term, as this translates to better company results and could perpetuate positive sentiment for U.S. equities. Conditions abroad will affect sentiment for foreign assets and this is a key current concern for markets—at the same time, though, uncertainly and pessimism can result in investment opportunity, as we all know.