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  Fed Ends QE, Rate Hikes Now on Radar
Posted Under: Government • Research Reports • Fed Reserve • Interest Rates

 
We count five key takeaways from today's policy statement from the Federal Reserve.

First, the Fed clearly raised its assessment of the economy.  Most notably, it deleted its long-standing reference to "significant underutilization" in the labor market, changing it to say that the underutilization in the labor market is "gradually diminishing."  This may not seem like much, but at the Yellen Fed a better assessment of the job market is a necessary step before raising rates and that hurdle is now much closer to being cleared. In addition, the Fed strengthened its language on consumer spending and completely deleted a reference to fiscal policy restraining economic growth.   

Second, quantitative easing is finished by the end of the week, as previously projected.  This doesn't mean the Fed's balance sheet will suddenly go back to normal.  Instead, the Fed will keep reinvesting principal payments from its holdings to maintain the balance sheet at roughly $4.4 trillion.  Look for the Fed to keep reinvesting principal through at least late 2015.

Third, the Fed is taking a more nuanced view on inflation, comparing market-based measures (such as the five-year forward inflation rate), which have diminished recently, to survey-based measures, which have remained stable.  The Fed pointed out that energy prices should hold inflation down in the near term but inflation should still head back up toward its target of 2%. 

Fourth, the Fed maintained its commitment to keep rates at current levels for a "considerable time," but added language saying rate hikes could happen sooner or later depending on how closely actual economic data match its forecast.  We think this means the Fed is getting very close to removing the "considerable period" phrase.  Look for the Fed to remove the language at the mid-December meeting, when Chairwoman Yellen will have a chance to fully explain the Fed's reasoning at the post-meeting press conference.     

Last, the two hawkish dissenters at the September meeting are now back on board with Fed policy while the lone dissent at today's meeting was a dovish one from Minneapolis Fed president Narayana Kocherlakota, who wants the Fed to commit to keeping rates low until inflation hits 2% and wants to keep quantitative easing going at the current slow pace at least through the end of the year. 

The bottom line is that the Fed has been and will remain behind the curve.  We believe the first rate hike could come in the second quarter of next year.  But nominal GDP – real GDP growth plus inflation – is up 4.3% in the past year and up at a 3.8% annual rate in the past two years.  A federal funds target rate of nearly zero is too low given this growth.  It's also too low given well-tailored policy tools like the Taylor Rule. 

In the meantime, hyperinflation is not in the cards; the Fed will keep paying banks enough to keep the money multiplier depressed.  But, given loose policy, we expect gradually faster growth in nominal GDP for the next couple of years.  In turn, the bull market in equities will continue and the bond market is due for a fall. 

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Posted on Wednesday, October 29, 2014 @ 3:34 PM • Post Link Share: 
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These posts were prepared by First Trust Advisors L.P., and reflect the current opinion of the authors. They are based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
 
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