insights

Thoughts from the Desk: What Lies Ahead for the Fed?

JOHN IBORG
PORTFOLIO MANAGER

FEBRUARY 02, 2018

FOMC Meeting Recap

On Wednesday, January 31, the Fed held its first FOMC meeting of 2018 and last of Janet Yellen’s tenure as Fed Chairman.  The outcome of the meeting largely met expectations, with no change to the target Fed funds rate.  The only thing to note was a modest hawkish tilt in the statement language which implied that 1) committee members remain optimistic about the labor market and ongoing growth, and 2) the committee is becoming more confident in the prospect of inflation rising closer to its 2% target this year.

Goodbye Janet…

Jerome Powell will assume the Chairman position next Monday.  That said it is worth taking a quick look back at Janet Yellen’s four years of service.  Following Bernanke’s regime of zero interest rate policy and quantitative easing, Yellen inherited a Fed in transition.  When she took over in 2014, short-term interest rates were practically zero and the Fed’s balance sheet had ballooned to $4.5tn before the end of QE.  This was uncharted territory for U.S. monetary policy.

It is too early to judge the complete impact and effectiveness of Yellen’s policy.  However, we cannot deny that under her watch forward guidance was effective during an unprecedented time.  First, the Fed was able to lift its target funds rate for the first time in over a decade, and four subsequent times thereafter, in a steady and predictable fashion that kept interest rate volatility low (Exhibit 1).  Yellen’s regime also engineered and initiated the unwinding of the Fed’s balance sheet in a way that did not spur much market turmoil.


Exhibit 1: Janet Yellen’s Fed successfully ended zero interest rate policy
Target Fed funds rate upper bound (%) 

…Hello Jerome

Several factors will guide the direction of monetary policy in the new Powell era.  One pressing factor is the composition of FOMC leadership.  Currently, the committee leans hawkish.  However, three governor seats (including the Vice Chair position) remain vacant and William Dudley, the President of the New York Fed and voting FOMC member, is set to retire in the middle of the year (Exhibit 2).  Trump’s picks for the three open governor positions could have a significant influence on the composition of Fed leadership and sway the speed of rising rates.

Exhibit 2: There are currently three vacant Fed governor seats
2018 FOMC voting members
 


Growth and inflation are obviously two other primary drivers. Weak growth and/or inflation weigh down the pace of Fed tightening.  Growth in the U.S. economy looks fine for now.  GDP is currently at 2.6%, in line with its post-crisis average.  Growth may also eventually start seeing a boost from tax reform. 

On the inflation side, things are looking better.  While inflation has sagged below the Fed’s 2% target for some time, wage gains data in today’s employment report touched a near-decade high pointing to increasing demand-pull inflation.  In response, intermediate to long-term UST yields rose 2-6bp.  With large corporations such as Walmart raising employee pay after the passage of tax reform, wage gains ought to remain firm.  This coupled with higher business investment and consumer confidence creates an improved backdrop for inflation.

The QS View

We believe that the outlook for monetary policy in 2018 is hawkish.  Though it is a conjecture at this point, based on his previous actions and comments, there is a decent chance that Trumps’ picks for the vacant Fed governor seats fall on the hawkish end of the spectrum.  Secondly, as mentioned above, growth and inflation look to be finding a solid footing.  All things considered, we are inclined to agree with both Fed and market projections for three hikes this year, which should push yields up along the curve, all else equal.  Marching forward, rising interest rates will continue to alter expected returns along with realized correlations and volatility across asset classes.  Now is a good time for investors to take stock of their respective asset allocation strategies.

 

Source: All exhibits and data are sourced from Bloomberg.

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QSCR-18309 (February 2018)