Off the wall thoughts on the Fed

We are heading into an eventful Fed meeting this week.  The market appears poised for the commencement of the long awaited shrinking of the Fed’s balance sheet.  The prevailing wisdom is the slow unwind of their holdings will not pressure yields higher.   If you are an equity analyst you have priced in that it will never have an impact on yields and if you are involved in credit, you may expect some small effect much later.  So despite the view that there will be little to no impact on yields from this action, the market also seems to be saying to the Fed that a rate hike should not be contemplated in conjunction with the introduction of balance sheet reduction.  

By strictly focusing on inflation readings, I understand why the market does not think a rate hike is needed this week.  But don’t use the new diet of the Fed as an excuse for them not to raise rates if you truly believe this balance sheet action will not have any impact.

This brings me back to focusing on inflation readings.  When it comes to fulfilling the mandates that are given to central banks by their respective elected governments, one could argue that the Fed is closest to ticking off all the boxes and should be the one acting in a relatively more aggressive manner to get rates back to neutral.  Way back when, Congress mandated the Fed to maximize employment, stabilize prices and try to achieve moderate long term interest rates.   With unemployment sub 4.5%, the PCE deflator stubbornly too stable at under 2% and the ten year bond yielding just over 2%, it looks like the overall mandate has already been achieved. 

Unfortunately nothing is that simple.  In 2012, the Fed issued a statement describing its strategy to best achieve the three objectives laid out by Congress.  In it, they stated that their focus would be to achieve and stabilize their favourite measure of inflation around 2%.  If this was met, the other two would fall into place.  

This 2012 statement has the market and, it seems, the Fed preoccupied by the strategy objective of achieving 2% inflation rather than on Congresses’ overall mandate.  This leads all involved to want monetary policy to remain very accommodative in order to nudge inflation slightly higher to attain the arbitrarily chosen 2% target.  But, is there a risk, with inflationary expectations anchored below their target level, that policy starts pushing the other two objectives of the Fed’s mandate away from their optimal levels?   

The most likely case is that we will find out.  The lower probability case is that the Fed starts to recognize that the job they have been given is largely complete and it is time to pick up the pace and get ready to rearm for the next recession.