Waddell & Reed

Market Perspectives


2013 Federal Reserve outlook: Low rates and a possible change at the top

Story Highlights

  • The Fed is sending mixed signals about its bond buying program.
  • The Fed's top policymakers for 2013 have a focus on economic growth.
  • The potential of Bernanke's retirement may make news later in the year.
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With any interest rate hike off the table, Federal Reserve (Fed) watchers will be left to focus on two issues in 2013: the future of the Fed’s bond buying program and the likely successors to Fed Chairman Ben Bernanke if, as many believe, he does not return to the Fed helm when his term expires in January 2014.

The low down

The Fed’s Federal Open Market Committee (FOMC) has definitely sent the market some mixed signals. The FOMC announced after its December meeting that the Fed would be making $85 billion in monthly asset purchases for an indefinite period, effectively expanding a third round of quantitative easing (QE3) launched earlier in 2012. The Fed also appeared to leave the door open to additional moves, suggesting that further easing could be forthcoming “if the outlook for the labor market does not improve substantially.”

But when the minutes of the closed-door meeting were later made available, they revealed that “several” Fed officials said they expect the Fed will slow or stop the bond purchases “well before the end of 2013.” According to the minutes, the Fed policymakers are concerned about financial stability and the size of the Fed’s swollen balance sheet. At its current pace, the Fed’s bond buying program would add about $1 trillion to the Fed balance sheet in 2013 if it continues through the end of the year. Although the comments did not relate to the Fed’s interest rate policy, the statements marked the first FOMC signal that it will eventually look to tighten its exceptionally loose monetary policy stance.

How it unfolds will hinge on the economy and particularly unemployment – which FOMC members expect to improve relatively little this year – and potential inflationary pressure. Among this year’s Fed policy voters, jobs are clearly the most important issue.

Ten of the 12 voters in 2013 fall into so-called “dove” camp, or those who generally see monetary policy’s primary mission as providing the fuel for economic growth – job creation in the current environment. The alternative viewpoint comes from the “hawks” who view monetary policy’s primary goal as price stability – particularly containing inflation. Among the 2013 Fed voters there are two probable hawks: Kansas City Fed President Esther George, a first-time Fed voter whose views align closely with her predecessor, inflation hawk and current FDIC vicechairman Thomas Hoenig; and James Bullard, the St. Louis Fed president who has questioned the concept that monetary policy is an effective tool for job creation.

Although Bernanke would be the most prominent dove, among the more notable policy doves is Chicago Fed President Charles Evans, who has for some time supported linking Fed policy directly to specific economic data instead of relying on subjective decisions. That idea, which some have started calling the “Evans Rule,” was instituted at the FOMC’s December 2012 meeting.

Under the rule – the first such policy guidelines in the Fed’s 100-year history – the FOMC has said it will hold its key Fed funds rate at the current historic low of 0 to 0.25% “at least as long as:”

  • Unemployment remains above 6½% ;
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  • Inflation between one and two years ahead is projected to be no more than a half percentage point above the FOMC’s 2% longer-run goal;
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  • Longer-term inflation expectations continue to be well anchored. Although the change is significant in terms of Fed’s policy communication, Bernanke said that the criteria did not imply any adjustments to recent policymaker views about the likely future policy path. Fed officials currently believe the newly-announced conditions for policy firming are unlikely to be met until 2015, according to Fed survey data.

Although the change is significant in terms of Fed’s policy communication, Bernanke said that the criteria did not imply any adjustments to recent policymaker views about the likely future policy path. Fed officials currently believe the newly-announced conditions for policy firming are unlikely to be met until 2015, according to Fed survey data.

 

Changing chairs?

Beyond policy, a possible reshuffling of Fed leadership could also make headlines later in 2013. Reports prior to the 2012 presidential election indicated that Bernanke, who began his tenure as Fed chairman in 2006, may not want to serve another term after his current term expires on Jan. 31, 2014. The markets will likely begin to expect some kind of announcement from the White House, either about Bernanke’s return or the nomination of a successor, at the end of the summer or early fall.

The speculation about the next Fed chairman, however, has already begun. Among current Fed officials, the front runner appears to be current Federal Reserve Vice Chairman Janet Yellen. Yellen, who would be the first female Fed chair, is already seen as being highly influential in forming the Fed’s policy views and is believed to have played a key role in the recent Fed decision to state specific inflation and unemployment targets. Her Fed resume is also lengthy. Prior to her appointment to vice chair in 2010 she was president of the San Francisco Fed for six years, and served a stint on the Fed’s Board of Governors during the Clinton administration in the mid-1990s. She later chaired Clinton’s Council of Economic Advisors.

From a specific policy perspective, Yellen is seen as among the most dovish of all the Fed’s senior officials. In a November 2012 speech Yellen laid out a Fed policy path that recommended the Fed hold its key interest rate at current levels into 2016 and below 1% until 2017. Yellen said the path, which is below what most currently expect from the Fed, would foster stronger employment growth, with the tradeoff being inflation slightly higher than the Fed’s 2% target starting in 2014 and continuing through 2018.

Other potential names that may emerge as possible appointments by President Obama to succeed Bernanke include Alan Krueger, chairman of Obama’s Council of Economic Advisors, former Clinton Treasury Secretary Lawrence Summers, and current Treasury Secretary Timothy Geithner.

 


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