Page 6 - ISQ UK_October 2017

INVESTMENT STRATEGY QUARTERLY

Federal Reserve Policy:

What’s Next?

Scott J. Brown, Ph.D., Chief Economist, Equity Research, provides perspective on the pace of balance sheet unwinding amid
the moving parts of monetary policy.

Federal Reserve (Fed) officials continue commonly called ‘quantitative easing’ or QE, were further
to emphasise that monetary policy will accommodation. The balance sheet surged as securities were
“The near-term
outlook remains remain data dependent. While the pace added to the Fed’s portfolio. The Fed has now begun to unwind
constructive for is uncertain, short-term interest rates are that. The Fed telegraphed its intentions and the pace of the
the stock market.” expected to rise gradually over the next reduction, so market reaction to the announcement has been
couple of years. The unwinding of the limited. It’s estimated that QE lowered the 10-year Treasury yield
balance sheet has begun slowly, but the pace will pick up over the course by about 100 basis points. Therefore, the balance sheet unwinding
of next year. is expected to raise long-term interest rates in the quarters ahead
(and this will be a multi-year process). Importantly, the Fed does
INFLATION not view the balance sheet unwinding as ‘active’ policy. Rather,
Much of the recent monetary policy debate has focused on the low it’s been described as ‘background.’ Officials have emphasized
inflation trend. Fed officials note transitory effects on inflation, such that the federal funds target rate will remain the main policy
as the sharp drop in wireless telecom services in March, and most lever.
believe that tighter labour market conditions will lead to higher
wage inflation. Yet, they are also aware that longer-term structural OVERALL
changes may make the inflationary response to low unemployment The near-term outlook remains constructive for the stock market.
more muted than in the past. Time will tell. Officials have signalled a The economy continues to expand, but not so fast that the Fed
willingness to wait for more information. rushes to ‘take the punch bowl away.’ However, demographic
constraints (slower growth in the labour force) will restrain GDP
INTEREST RATES growth and perhaps present some challenges for the markets in
While the Fed has raised short-term interest rates in the first half the months ahead.
of the year (still very gradual by past standards), credit has
generally become easier, suggesting that there is more work to While future monetary policy moves are always uncertain, the future
do in order to get the economy on a more even keel. Fed Chair appears more clouded as we look beyond the early part of 2018.
Janet Yellen has said that the federal funds target rate is not far Trump will have a number of Fed governor positions to fill and will be
below what would be considered a 'neutral rate', a level neither able to shape the Fed’s leadership. The choice of Fed chair remains
contractionary nor expansionary. However, the neutral rate is key. Ben Bernanke and Janet Yellen were the right people at the right
expected to rise over time as the economy improves – hence, an time.
outlook of gradual policy rate increases.

During the financial crisis, the Fed effectively hit the lower bound
on short-term interest rates. Large-scale asset purchases,

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