Market Economics | Interest Rate Strategy - BNP PARIBAS ...

The more difficult decisions will come as QE2
nears completion and the Fed has not made
much progress on its mandates
The real debates will occur as we move toward
completion of the programme. No member of the
FOMC has indicated that he or she expects
significant progress on the Fed’s dual mandates for
maximum employment and stable prices, but the
tone of the economy will set the tone of the policy
debate.
Should the economy continue to perform reasonably
well, even if final demand growth moderates from
what should be a very strong Q4, there will be strong
opposition from the hawkish members to any further
expansion in the balance sheet.
At this point, it seems that further expansion of
securities purchases would require significant
deterioration in the economy. Such a scenario would
also raise questions about the efficacy of Fed policy
to date, however. There is thus certain to be
opposition to QE3 in any case.
The most likely path of policy would be completion of
QE2, maintenance of the balance sheet for some
time as progress toward the mandates will be slow in
coming, then allowing maturing securities to
gradually reduce the size of the Fed’s portfolio. Once
i) the unemployment rates has fallen to 8.5% on job
growth, rather than decline in labour force
participation; and ii) wages have begun to stabilise,
suggesting gradual improvement in purchasing
power that will stabilize core inflation, the Fed will be
ready to normalise rates to 1.0%.
The Fed has tools in place, including the Term
Deposit Facility and reverse repos, that it believes
will help sterilise the trillions of dollars in excess
reserves and give it greater control over short-term
rates. Thus the FOMC believes it will be able to raise
rates even as it maintains an elevated balance sheet.
This is a shift from the last time we thought about the
sequencing of Fed tightening. At the beginning of last
year, we were thinking that the Fed would have to
bring down excess reserves to a considerable
degree before tightening could get underway, which
could include asset sales.
However, Chairman Bernanke stressed in a speech
in late October 2010 that, with the liquidity absorption
tools the Fed has developed: “I am confident that the
FOMC will be able to tighten monetary conditions
when warranted, even if the balance sheet remains
considerably larger than normal at that time.”
We continue to think that tightening is a good way off
given the pervasive weakness in the US economy
that remains even after a solid quarter of growth.
While many global investors and policymakers
believe the Fed should consider the global
ramifications of its policies, the FOMC is likely to
continue to focus on its domestic mandates. We are
in a period of increasing dichotomies; global markets
and policymakers have calibrated their policies
based on Fed actions in prior cycles. However, the
US is lagging global performance in the current
recovery. This is leading to rising tensions as the Fed
stays easy and emerging-market central banks are
reluctant to tighten even as their economies verge on
overheating.
Julia Coronado 20 January 2011
Market Mover
12
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