Economic Commentaries


Were it not for nagging geopolitical tensions, Fed Chair Janet Yellen’s upcoming policy discourse at the Kansas City Fed’s annual séance would be uppermost in the market’s mind. Her speech is to be delivered at the Jackson Hole, WY. Conference this Friday.

We are not expecting new policy initiatives. Rather we think Janet will reaffirm the Fed’s intention to end its asset purchase program this fall. She is likely to highlight the improving condition of the labor market while emphasizing that more healing needs to occur. She may also take a victory lap on inflation as recent market concern about an acceleration is proving alarmist. Finally, we think the Fed Chair will emphasize that the Fed’s course of future action will be cautious and deliberate.

We doubt any of this would stop analysts from speculating on the timing of future rate hikes. However, we think this speculation is wrong headed and could precipitate a policy mistake. Specifically it is important that over the past several months the yield spread between two and ten year treasury notes has narrowed by more than one-half percentage point. This yield curve flattening has occurred as short rates have edged up while long rates have fallen amidst low inflation, economic weakness abroad, and diminishing supply. Were the Fed to begin raising short rates in this environment a further narrowing of the yield differential would likely occur as markets anticipate even more sluggish activity ahead.

Rather than manipulate short term rates, if the Fed’s is intent on adjusting policy it should massage its balance sheet. By not reinvesting interest earned on its securities holdings and/or not reinvesting the proceeds from maturing securities the Fed could begin shrinking its balance sheet while increasing supply at the long end. This might satisfy those demanding policy restraint; it would give the market what it wants namely more bond supply; it might steepen the yield differential by perhaps boosting long term yields which would be a positive for the economy, financial institutions and financial markets.

If we are right and economic growth remains around 2.5% while inflation remains below the Fed’s 2% target, we do not see why the Fed should alter policy in any way. In fact if job growth remains moderate while labor force participation continues to edge higher, six months from now the jobless rate could even be marginally higher than the current 6.2% rate.

Nevertheless, to satisfy those clamoring for restraint we think balance sheet manipulation would be superior to interest rate manipulation. But having said this, if our forecast is right we would not be surprised if the timetable for action were pushed back with many beginning to wonder what more the Fed might do to support the domestic and global economy which, by the way, clearly needs support.

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