Fed Maintains Tapering Pace, But Will Keep Interests Rates Low

gty_janet_yellen_ll_131114_16x9_992By Robert “R.J.” Raglin ’16

The Federal Open Market Committee announced after its meeting on Wednesday that it will continue to taper quantitative easing by another $10 billion, reducing its monthly bond purchases to $55 billion. The Fed will cut monthly mortgage-backed security purchases from $30 billion to $25 billion and treasury purchases will drop from $35 billion to $30 billion. These actions were expected by many investors as the U.S. labor market continues to make progress and as the FOMC has cut its economic stimulus by $10 billion in both December 2013 and January 2014.

In light of these changes, the Fed will continue to hold interest rates at record low levels; however, it has changed its policy. In late 2012, the Fed announced that it would not raise interest rates above 0% until the unemployment rate fell below 6.5% provided that inflation stays below 2.5%. The Fed ended this 15-month declaration and had a different tone after the FOMC meeting. The Fed will now assess progress toward its objective of maximum employment and an inflation rate of 2% differently. While making judgments, the Fed will take into account a wide range of information including: indicators of inflationary pressures and inflation expectations, readings on financial developments, and measures of labor market conditions. Janet Yellen, Chairman of the Federal Reserve, stated that more specifically the Fed will analyze the share of workers who have been unemployed for six months or more, the share of adults who are holding or seeking jobs, the portion of workers who hold part-time jobs, but say they would rather have full-time occupations, and the rate at which people are quitting jobs. Yellen said in her press conference after the FOMC meeting, “new measuring sticks were necessary because the unemployment rate had fallen more quickly than expected, while other economic indicators, like inflation, remained weak. The Fed will keep short-term rates near 0% ‘for a considerable time’ after the bond-buying ends, particularly if inflation remains sluggish.” This could be for as long as six months beyond the end of the stimulus which is on pace to end this Fall. This new outlook by the Fed has lead investors and economists to believe that interest rates will begin to increase long before the end of 2015.

The question now becomes how these actions will affect the market. In futures, prices indicated investors’ expected rate for the Fed’s federal funds rate for June 2015 moved up from 0.28% before the FOMC meeting to 0.36% after the meeting. This response represents the sensitivity of the market to the Fed’s interest rate decisions after seven long years of central bank action to stimulate and stabilize the economy. The Fed faces a tremendous challenge as it chooses monetary policy. As the economy continues to recover, the Fed gradually increases its grip on money, but if it moves to quickly it could undercut the recovery it has been working so hard to support. On Wednesday, The Dow Jones Industrial Average finished down 114.02 points, or .7%, at 16222.7, while 10-year Treasury Notes rose 0.096 percentage point to 2.770%. This activity by the market demonstrates how nervous bond investors are about rising rates.

The economy is steadily recovering with unemployment reaching 6.7% in February. It will be very interesting to see the Fed’s actions at the FOMC meeting in April. According to forecasts released by the Fed after the meeting, 10 of 16 officials expect the Fed to raise interest rates to 1% or higher by the end of 2015. Furthermore, most officials see rates rising to 2.25% by the end of 2016, up from a median estimate of 1.75% in December. During normal economic times the Fed believes interest rates should be 4%, but it does not seem likely this rate will be reached anytime in the foreseeable future.

http://www.forbes.com/sites/samanthasharf/2014/03/19/fed-cuts-monthly-asset-purchases-to-55-billion-maintaining-pace-of-taper-market-awaits-yellen-remarks/

http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm

http://online.wsj.com/news/articles/SB10001424052702303802104579449321003326880?mg=reno64-wsj&url=http%3A%2F%2Fonline.wsj.com%2Farticle%2FSB10001424052702303802104579449321003326880.html

http://www.washingtonpost.com/blogs/wonkblog/wp/2014/03/19/fed-changes-guidance-on-short-term-interest-rates/

http://www.npr.org/blogs/thetwo-way/2014/03/19/291447656/fed-continues-tapering-economic-stimulus

http://stream.wsj.com/story/latest-headlines/SS-2-63399/SS-2-487400/

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