SITUATION ANALYSIS
Preparing for the Fed’s next move
Executive summary
The Federal Reserve (Fed) has taken unprecedented action in the five-plus
years since the global financial crisis created a substantial threat to the
economy. The Fed’s primary focus was to maintain liquidity in the U.S.
financial system. After exhausting its primary policy tool­­—lowering interest
rates to near zero percent—the Fed determined that more had to be done.
The Fed began to use more unconventional means, notably a strategy called
quantitative easing (QE). This approach involved the Fed continuously buying
bonds on the open market. Over the years, the Fed dramatically expanded
its balance sheet as it invested significant sums in U.S. Treasury bonds
and mortgage-backed securities. The goal was to drive interest rates lower,
encouraging investors to move away from fixed income investments and to
add risk assets, such as stocks and real estate securities, to their portfolios.
Over time, this strategy had the desired effect on investors and helped ease
the economic fallout from the financial crisis.
Now that the economy appears to have stabilized, the Fed and other central
banks around the world need to transition from their aggressive “easy
money” policies to a more neutral stance. The challenge is to execute this
transition while keeping the economy on a stable path and avoiding another
crisis. Investors have demonstrated some nervousness about the potential
impact of the Fed altering its current policies, resulting in a more volatile
market environment in 2013.
Because this transition is from unprecedented policies, the sense of anxiety is
not unjustified. Nevertheless, we anticipate that the Fed will “go slow” in this
process. It seems likely that the Fed will not adjust short-term interest rates
upward until the unemployment rate drops further (to 6.5 percent or less) or
inflation becomes more of a concern (higher than a 2.5 percent annual growth
rate). Unwinding its balance sheet will probably be a gradual process. The most
likely scenario is that the Fed will allow the bonds it holds to mature rather
than sell them on the open market as a way to phase out of its QE policy.
With that as a backdrop, this paper provides insight on the role of the Federal
Reserve as it relates to the economy and markets. It also explores in more depth
the Fed’s current policies, how they differ from previous actions and what the
implications could be going forward.
Important disclosures provided on page 5.
Thoughts on the Fed’s past,
present and future direction
• Understanding the role of
central banks
• How Fed policies effect the
economy and markets
• Use of unconventional
stimulus measures
• Where the Fed likely goes
from here
SITUATION ANALYSIS | Preparing for the Fed’s next move
The purpose of a central bank
A central bank is a public institution charged with
managing the availability and cost of money and credit,
as well as overseeing, regulating and maintaining a sound
and stable commercial banking system. The Federal
Reserve is the central bank of the United States and its
explicit functions include the following areas:
• Provide financial services to banks
• Maintain the stability of the financial system
• Supervision and regulatory functions
• Conduct the nation’s monetary policy with the
objectives of maximum employment, stable prices and
moderate long-term interest rates
The nation’s monetary policy can be “expansionary” or
“contractionary” and is implemented a number of ways:
• Targeting the monetary base via “open market
operations,” i.e., buying or selling bonds. This is the
most widely used policy tool, which indirectly has an
effect on interest rates with the intention of helping the
broader economy by making capital cheaper or more
expensive. The Fed has been buying bonds (thereby
lowering interest rates) in recent years. This has been
more widely known as “money printing.”
• Changing the amount of required reserves (liquid
cash) that banks must hold to cover obligations, which
changes the availability of loanable funds.
Historically, Fed policy has had an effect on both the
economy and the stock market. This is most apparent
in situations where the economy is growing slowly and
requires some stimulus. When the economy falters, the
Fed has historically provided stimulus by lowering shortterm interest rates and withdrawn stimulus when growth
and prices get overheated by raising those rates (the rates
rise or fall due to the amount of money being injected into
or withdrawn from the system). The mechanism by which
this happens is that the Fed purchases bonds, thereby
placing more money in bank reserves held at the Fed.
The higher quantity of money causes the Fed funds rate
(interest rates at which banks lend to one another) to go
down. Alternately, when the Fed wants to raise rates, it
can sell bonds to “mop up,” or remove, excess liquidity
from the system.
As we’ve seen lately, stock market investors initially
respond positively to the promise of more stimulus and
negatively when it seems the Fed may start winding down
stimulus. There’s a commonly heard phrase, “Don’t fight
the Fed.” Basically, this means that when the Fed is taking
action, it’s smart to be on the same side of the ledger.
Changes to short-term interest rates, the Fed’s traditional
policy tool, have historically had a positive effect on equity
markets in either direction, but the movement is more
pronounced after rate cuts. The Fed’s recent purchases
of assets to increase liquidity have also been good for risk
assets (such as equity securities).
• Central bank lending of short-term funds to banks to
meet temporary liquidity shortages.
The historical relationship between Fed policy,
the economy and the markets
In the United States, the Federal Reserve was created
by an act of Congress in 1913 mainly to prevent banking
failures (panic and crises) by providing liquidity within the
banking system (so banks could honor withdrawals). Like
most central banks, the Fed’s primary mandate was to
maintain stable prices, (e.g., to fight inflation and deflation).
In 1977, Congress amended the Federal Reserve Act to
include a second mandate of full employment.
Important disclosures provided on page 5.
20%
15%
% change
As with most central banks of the developed world, the
Fed operates independently of direct governmental or
political control and does not determine fiscal policy, such
as setting tax rates, budgets or spending targets. They
strive for a moderate rate of inflation and maintain credit
as needed by injecting stimulus when an economy flags,
and withdrawing stimulus when things get overheated.
S&P 500 performance following interest rate hikes and cuts
(Period: 1946-2008)
10%
5%
0%
After Rate Hikes
6 months
All Years
After Rate Cuts
12 months
Source: S&P Equity Research
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SITUATION ANALYSIS | Preparing for the Fed’s next move
Effects of QE on the S&P 500 performance
(Period: March 18, 2009 – March 1, 2013)
What, if anything, is different this time?
Paying the banks interest on their excess reserves (known
as IOER) is a new, additional policy tool that the Fed
(along with other global central banks) has started to use
to conduct its monetary policy operations. The IOER rate
is currently set at 0.25 percent. It essentially serves a few
purposes, including putting a floor on the level to which
rates can fall (as interest rates are already extremely low).
This is important to prevent deflationary spirals and it helps
to control a large release of liquidity into the economy
should the Fed think it appropriate. It should be noted that
there is no constraint on bank lending other than the public
demand for credit, which is currently fairly low.
One intended effect QE is having is boosting risk-taking
in financial markets where investors are seeking higher
interest/dividend payments. Because interest rates are
so low, some investors are buying up riskier assets in an
attempt to achieve a higher yield.
Central banks have traditionally been limited to using
control of short-term rates to effect policy, expecting
fiscal policy to be the primary driver over the longer term.
However, QE has had an effect on long-term rates as well.
This has caused concerns that the Fed may be acting as a
fiscal authority, causing distortions in financial markets (as
is currently the case in Europe).
Important disclosures provided on page 5.
1600
1500
S&P 500 Index Price Level
Widespread usage of quantitative easing (QE) started off
as a central bank response to the 2008 liquidity crisis that
followed the bankruptcy of Lehman Brothers. As interest
rates moved down toward zero, the Federal Reserve
saw the need to utilize less traditional policy tools. QE is
similar to open market operations, except it goes one step
further and buys financial assets and long-term bonds
rather than just short-term bonds. The Fed deposits cash
into the accounts of banks (“reserves”) as payment for the
financial assets it purchases from the banks. Historically,
the Fed has not paid any interest on excess reserves
held by the banks in these accounts. Instead, the excess
cash on the books of the banks strongly incentivizes the
banks to earn a higher return on the money by lending it
out. Because of all the extra money available for lending,
credit for the general public becomes cheaper and more
available, which compels companies to invest in projects
and employ more people, leading to economic growth.
Asset purchases, such as QE, not only holds down
rates, making credit cheaper, but also makes other asset
classes, such as stocks and real estate, relatively more
attractive. The wealth effect of rising equities can also
help drive economic growth.
1400
+6%
1300
+5%
1200
1100
+10%
+15%
1000
900
800
700
Mar
2009
+47%
Mar
2010
Mar
2011
No Policy
QE1 Expansion
QE2
Operation Twist Extension
QE4
Mar
2012
Mar
2013
Operation Twist
Source: Bloomberg, Doubleline Capital
The relationship in the United States between interest
rates, the Fed’s unemployment mandate and corporations
(with their focus on short-term profits) has become more
complicated and will likely have longer-term implications
for economic growth. In the normal course of conducting
business, companies make a choice between investing in
capital (machinery, technology, etc.) to increase capacity
and productivity and investing in labor. This decision can
be significantly impacted by both the level of interest rates
and policies that affect labor costs. Generally speaking,
lower interest rates make capital investment cheaper
relative to labor and the possible rising costs of adding fulltime employees (health care, regulatory overhead) skews
the equation even further. The positive employment impact
from industries benefitting from Fed-induced lower rates,
such as housing, may be offset by that substitution effect.
It will continue to be important to monitor the struggle
between two powerful forces:
1.Policy that encourages capital investment through low
interest rates and available liquidity
2.An environment where globalization and productivity
enhancement reduces the need for that capital
investment
Despite having interest rates at historically favorable levels,
capital investment has been disappointing. Productivityenhancing technology (stemming from prior capital
investments) and cheap global labor have allowed many
companies to continue to grow profitably even as the
global economy struggles its way through the deleveraging
process. This is leading, however, to a lack of new longterm capital investment, restricted hiring, flat wages and
massive cash balances. How long this lack of investment
can be sustained without causing damage to long-term
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SITUATION ANALYSIS | Preparing for the Fed’s next move
economic prospects is a significant question. On the other
hand, policy that encourages the productive deployment
of this cash could be a boon to economic growth, though
we may have to accept higher unemployment as a
structural rather than cyclical problem.
What are the current and future economic/
investment implications of global central
bank policy?
Despite the recent volatility, current market conditions still
reflect cautious optimism that central bank balance sheets
will remain manageable enough to be trimmed once
growth is restored, and that QE can be unwound in an
orderly fashion. In the United States, the perception is that
while the economy is growing, it is too weak and inflation
too low for the Fed to stop easing—which translates to
a positive environment for equity markets. In Europe, the
European Central Bank (ECB) continues to attempt to buy
time for politicians to introduce reforms that lead to tighter
monetary and fiscal integration, though progress remains
uneven. In Japan, new QE has led to a declining yen,
which is aimed at breaking the country’s decades-long
economic malaise by both increasing inflation to 2 percent
and becoming a more competitive exporter of goods. The
Japanese equity markets moved up significantly on the
announcement of this policy change though it remains to
be seen if this represents a true turning point for Japan or
another false start.
While central banks have been able to use QE to continue
to address their mandates even as short-term interest
rates approached zero, monetary policy does not solve
fiscal (taxation and spending) problems as much as it
buys time for governments to solve them. Central bank
action around the world appears to be succeeding in
fighting big short-term tail risks, but it’s still unclear
if enough time can be bought for governments to fix
long-standing structural fiscal problems and resume
unaided economic growth without a crisis (particularly
in the eurozone). Unfortunately, these solutions require
significant political compromise in an era where that is
difficult to come by.
In the United States, the unemployment mandate
complicates things further. Trying to push unemployment
lower via continued QE may eventually cause a bubble in
financial assets and/or inflation, and tightening too soon
based on a falling unemployment rate (which itself may
be overstating the health of the economy) may cause a
recession. In the absence of sound long-term fiscal policy
in the United States, the actions of the Fed may encourage
Important disclosures provided on page 5.
the popular perception that it (the Fed) is merely a serial
bubble blower (technology, housing, bonds and stocks).
Eventually, quantitative easing will have to be unwound.
We have recently seen increased volatility in financial
markets following Fed Chairman Bernanke’s comments
about the potential timing of this exit. While he has
reiterated that economic conditions will dictate the
timing and pace of the withdrawal, as well as his belief
that the process need not be disruptive, his refusal to
name specific targets or parameters has led to continued
uncertainty and unrest in the markets. Given the relative
softness of economic data, and a lack of headline
inflation, a couple of outstanding questions remain:
1.To what extent will new data (unemployment versus
inflation) impact upcoming policy decisions?
2.How will financial markets respond?
In brief, an effective exit from QE in the United States
should be enabled by an economy that can sustain
healthy growth and stronger employment without it.
The assets on the Fed’s balance sheet could be held
as long as necessary to prevent the tightening effect
of significant asset sales and the realization of losses,
though keeping the money in the private economy
could eventually be inflationary. We believe this gradual
unwinding to be the likely outcome. A more disruptive
U.S. exit is possible, if less likely, and it may be caused
by the need to control an asset price bubble while the
economy remains unsteady. In this scenario, a drying up
of global liquidity could lead to recession. Government
borrowing costs would likely go up as rates rise without
the offset of a healthy economy. Emerging market
economies that export to the developed world could be
particularly susceptible to capital outflows and exchange
rate volatility. Concern about this possibility was reflected
in the recent move down from market highs. Tapering
(i.e., a reduction in the level of asset purchases by the
Fed) is still accommodation. However, if the Fed’s Evans
Rule is any indication, actual tightening won’t happen for
some time. The Evans Rule, adopted in December 2012
and named after Chicago Fed President Charlie Evans,
dictates that monetary policy should not be tightened
until the economy heals past a certain point. In this case,
that point is determined by an unemployment rate below
6.5 percent and forecasted inflation above 2.5 percent.
However, as noted above, Chairman Bernanke has not
committed himself to any hard and fast rules around
tightening, saying only that he is looking for a “broadbased improvement in a range of indicators.”
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SITUATION ANALYSIS | Preparing for the Fed’s next move
3.0%
11%
Inflation
10%
Dec 2016
9%
2.5%
Unemployment
2.5%
8%
Nov 2014
6.5%
7%
6%
2.0%
5%
4%
3%
1.5%
2%
1%
0%
1.0%
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Projected
Trend from peak
Trend from trough
Inflation rate
Unemployment rate
Trigger points for Fed’s “Evans Rule”
Source: Bureau of Labor Statistics, U.S. Bureau of Economic Analysis calculations
Around the world, central banks are engaging in
unprecedented actions in order to give governments
the time to get their fiscal houses in order. Whether
through the use of QE, the payment of interest on bank
reserves or even just plain jawboning (public discussion),
thus far they have done a remarkable job of maintaining
economic stability through a period of global deleveraging
and geopolitical change. As evidenced by the recent rise
in volatility in financial markets, the jury is still out on how
long current Fed policy should be maintained, whether
effective long-term fiscal policy is politically feasible, and
whether the transition from extraordinary monetary policy
can be managed without crisis.
Summary views and guidance
Central banks play a critical role in maintaining the stability
of our financial system and the economy as a whole. The
unprecedented strategies implemented by the Fed in
recent years have generally been successful in limiting the
impact of a historic financial crisis. Now the challenge is to
transition to a more normal policy stance without putting
the economy at risk. We expect the Fed will be successful
in meeting this challenge, but the process may result in
some volatility in the investment markets.
While the use of alternative investment strategies may not
be appropriate for all clients, given our belief that interest
rates are likely to rise, thereby reducing the principal value
of bonds, you may wish to consider including hedged
fixed income or equity funds in your portfolio. For more
information about these types of investments and whether
or not they may fit with your portfolio objectives, please
contact your Wealth Management Advisor.
Contributed by U.S. Bank Wealth Management Economic Work Group Members:
• Robert L. Haworth, CFA – Senior Investment Strategist
• Julie C. Mello – Portfolio Manager
• Seth A. Scholar – Portfolio Manager
• Natasha M. Wayland – Portfolio Manager
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This commentary was prepared September, 2013 and the views are subject to change at any time based on market or other conditions. This information represents the opinion of U.S. Bank and
is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to
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