Fed Notes – January 29, 2014


Written by: Jon McGraw

After the much-anticipated taper in December, what could the Fed possibly do now to follow-up? Turns out, more taper.

This is despite economic data in recent weeks looking a bit less robust than in the weeks prior (however, there may be natural seasonal volatility associated with this, not to mention extreme weather). The magnitude of the updated tapering pace is an additional $10 billion in bonds per month, split equally between Treasuries and mortgage-backed securities, which brings the monthly purchases down to $65 bill./mo., from the $85 bill./mo. initial level.

Other Fed wording referenced economic activity having ‘picked up in recent quarters (compared to the ‘moderate pace’ used in December), as well as faster business fixed investment and household spending. Commentary has also suggested ‘mixed’ indicators but improved employment conditions, albeit still a trouble spot. The anticipated moderate economic improvement and interest rate modelling are generally unchanged from trend (with expected Fed Fund rate hikes in 2015, although some economists doubt it will happen this quickly). So, policy remains data-dependent, but a bit more reflective of underlying improvement than meetings in 2013.

We mention this frequently, but there are a few key metrics to watch if one is interested in taking guesses at Fed policy (not always a wise game to bet on): unemployment, inflation and economic growth. The first two are the direct mandates the Fed is beholden to, while the last naturally affects impacts their direction.


  • Unemployment levels are improving, but haven’t reached ideal targets and remain tempered relative to similar points in previous business cycles. The Fed’s threshold of 6.5% could be reached sooner than later, which may again stretch the communication efforts and power of ‘forward guidance.’ A debate remains as to whether conditions are cyclical or structural, and how much monetary policy can do to assist with this.
  • Inflation to some degree is desirable, as it represents a natural by-product of growth (relative to the opposite condition of systemic deflation). However, there is an understandable concern about the aftermath when large amounts of monetary stimulus are shoveled into the system. Those taking the contrary view argue that large holes of spare capacity left over from the Great Recession are still being ‘filled’ in and are keeping inflationary pressures at bay. Banks are lending more, but not excessively, which has likely kept potential pent-up monetary pressures from being transmitted. From a high-level view, we’re not seeing inflation seep into conventional indexes, but measures like wage growth bear watching for signs of conditions changing.
  • Economic growth is improving, but remains low compared to prior economic cycles. Continued debate exists about the causes: Did the depth of the Great Recession cause lasting scars that are taking much longer to heal than thought? Are demographic/aging trends underpinning a lower ‘new normal’ in years to come for developed nations? Is technological innovation and ‘productivity’ raising the bar for benefits at the margin?

This was the last meeting with Bernanke as the head, and there were no dissenting votes. The newly reconfigured FOMC, with the next meeting in mid-March, will feature Janet Yellen as chair as well as a revamped set of voting members—several of which happen to be more inflation-‘hawkish’ and supportive of the QE wind-down, while one or two others continue to fall in the ‘dovish’-easing camp and feel additional Fed help is needed. Perhaps these will cancel each other out.

Markets reacted negatively at the time of release, but that isn’t unexpected (the Fed is pulling the punchbowl away, albeit slowly). From an investment standpoint, the 30,000-foot view tells us that reduced easing and ultimately higher interest rates are a byproduct of stronger economic growth. Historically, stock markets have continued to perform well during modest rising rate periods, and valuations near normal could well perpetuate such returns. However, bond funds naturally face a shorter-term headwind as higher yields take time to be incorporated in and can’t offset the hit on principal. At the same time, there is an opportunity cost in going too defensive and ‘cash-like’ where yields continue to hover at zero for the time being. At some point, those cash yields will increase with the Fed Funds rate but that time still looks to be quite a way off.

We’re sure you heard it at the time or at least heard about it: In Obama’s State of the Union speech last night mentioned a new product geared towards savers falling under certain income limits and lacking a decent retirement plan. From what it sounds like on a preliminary basis, these might be similar to the classic savings bonds used for decades, with a rate tied to that of the Federal thrift savings plan’s government (‘G’) option that invests in short-term non-marketable Treasury securities (the ‘G’ fund earned 1.7% last year, so better than other government bonds) and has some Roth IRA-like taxation characteristics. We’re sure there will be more to come, but we have reservations about such a product solving America’s retirement savings dilemma, especially on a long-term after-inflation basis.

Hold onto your hats – the political winds are starting to blow…