The Federal Reserve, Five Years In…

Last week we saw the Federal Reserve questioning the efficacy of quantitative easing.  Federal Reserve Board member William English presented a paper to the International Monetary Fund about the Fed’s framework for monetary policy, in which there was an implicit assumption that tapering would continue to take place and that there is little potential variability in the schedule of winding all asset purchases down by the end of next year.  The paper advances and expands on Fed Chair nominee Yellen’s “optimal control” concept, laid out in a speech from November 2012.  Current market expectations are for short-term rates to stay low until early 2015, which is in line with estimates based on Taylor Rule models.  English’s paper advocates a policy with a zero feds fund rate as late as 2017.  Furthermore, the paper promotes the idea that lowering the employment threshold before raising rates to 5.5% from 6.5% would help convince the market of the fed’s commitment to keeping rates lower for a longer period of time.  The model predicts that this will lower unemployment at a faster rate, while potentially pushing inflation above the 2% long-run target temporarily.  Other Fed research papers have emphasized the effectiveness of forward guidance on rate policy in shifting market expectations and supporting the economy as opposed to further balance sheet expansion.  Earlier in the year, research by the San Francisco Fed argued that rate guidance is a more powerful tool than asset purchases.  Whichever tool or method the Fed uses to communicate policy, it is becoming clear that the risk of higher term premiums is increasing and will likely continue to do so over the next two to four years.  We are positioning portfolios to mitigate potential interest rate risk, shifting allocations to take advantage of probable volatility, and selecting credits that will perform well in this environment.