Monetary policy – a game of give and take

In our opinion, the Federal Reserve had to offer something up to get the market’s permission not to “spike the punch bowl” as aggressively as it had been doing. This included strong language around the expectation of rates remaining unchanged “well past” the threshold of 6.5% unemployment being reached. Additionally, the Fed’s Summary of Economic Projections showed the median forecast of federal funds for both 2015 and 2016 declined by 0.25%, implying rates will remain lower for longer. Furthermore, slowing purchases by $10 billion a month is a drop in the bucket relative to how much liquidity it will continue to inject into the system.

Prior to initiating a reduction in the amount of bonds purchased, the Fed had to avoid a repeat of the so-called “taper tantrum” this summer, when investors pulled forward a rate increase, despite the Federal Open Market Committee’s (FOMC’s) forward guidance on rates. Back in May, when tapering talk began, Eurodollar forwards and fed fund futures priced in a tightening as early as next year. In our view, however, the Fed couldn’t allow that tightening to happen again, particularly because the effectiveness of quantitative easing is being called into question by market participants and Fed officials alike.

The recent spate of better economic data certainly provides a more constructive backdrop for the Fed to initiate the taper. However, keep in mind the pattern of the past few years, which showed economic optimism increasing into year-end only to be met with subpar growth. At the end of the day, we believe excessive liquidity, which leads to asset inflation, isn’t a fundamentally sound long-term policy for successful economics.

The views expressed represent the Manager's assessment of the market environment as of December 2013, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

Eurodollars are U.S. dollar–denominated deposits at foreign banks or foreign branches of American banks. Forwards and futures refer to types of derivative contracts in which a buyer agrees to purchase an asset (or the seller to sell an asset) at a predetermined future date and price.

12/13 (11779)

Notes from the desk