The Independent Market Observer

3/15/13 – What Does the Fed Do Next?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Mar 15, 2013 10:50:06 AM

and tagged Market Updates

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The recovery continues. Employment figures keep improving, wages are edging up, and the unemployment rate is dropping. At some point, the Fed will have to make a decision to start pulling back, and that could be a problem.

Much of the country’s current economic strength stems from the very low interest rates the Fed has engineered and maintained. Housing, for example, is close to all-time-high affordability levels, mostly due to rock-bottom mortgage rates. My interest expense has declined by more than a third in the past couple of years, as I refinanced twice. For homeowners who can refinance, doing so adds to their cash flow and purchasing power. For new buyers, lower rates make housing not only affordable but cheaper than renting.

At some point, the Fed will have to start putting rates back up. A good question here, though, is why? Why can’t the Fed just leave rates low indefinitely and keep the party going?

The answer, from a legal and institutional perspective, lies in the Fed’s dual mandate: to maintain stable and low levels of price inflation and also low levels of unemployment. This dual mandate is unusual in the central banking world; most countries’ central banks are specifically and solely tasked with maintaining price stability.

Historically, the Fed has also focused on price stability, usually expressed as keeping inflation low. That strategy has made sense, as inflation in the U.S. has typically been a much larger problem over time than unemployment. Over that time period, the job of the Fed was aptly described as taking away the punch bowl just as the party got going.

This time, though, really has been different. Unlike in recent recessions, when inflation lurked and unemployment never got that bad, we’ve had not an inflation risk but a deflation risk. Unemployment was at levels not seen for decades. In the past crisis, the Fed actually pursued its dual mandate in a way that hadn’t been seen before—by encouraging inflation to counteract the risk of deflation and, at the same time, trying to boost demand and, therefore, employment.

Much of the criticism of the Fed has arisen from the fact that its actions have been very different in this crisis than in past ones. But, so far, the results have justified the actions. At some point, though, the risk of inflation will start to rise again, and the Fed will have to revert to its standard playbook and raise rates.

We’re still a long way from that point. Before raising rates, the Fed would first stop buying bonds in the open market and start to dispose of its large stock of them. Only then would rate increases come into play. But, even by starting the process, by slowing or stopping its purchase of bonds, the Fed would be flashing a powerful signal to the markets that the old rules were coming back—and we would certainly see the markets react.

Recent economic strength suggests that point could arrive a lot sooner than previously thought. Some economists now project that the Fed could start to back off as soon as the second half of this year. I think that’s probably too aggressive, but the fact that we’re even discussing it means the recovery is much further advanced than expected. Yes, raising rates will be a problem. But it will actually be a pretty good problem to have.

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