A primer on the Fed’s discussions on changing its forward guidance
|Key takeaways
In this piece, we take a closer look at the Fed's ongoing discussions on how to strengthen its forward guidance, which we identify as the Fed's main concern, from both a theoretical and practical point of view.
The Fed has two options: time-based (like yield curve control) or outcome-based (like an average inflation target) forward guidance (or a mix).
We argue that the Fed is considering implementing a cap on 3yr US Treasury yields at 0.25% (the upper end of the Fed's target range), i.e. the Fed can accept the yield trading below but not above the cap.
While the YCC policy may be successful under some key assumptions, there are also some drawbacks. The Fed may have to buy the whole market if the policy is not credible and interest rates may move higher for both good and bad reasons. In addition, the reaction function already seems well understood by investors with no rate hikes priced in over the coming years.
In our view, outcome-based forward guidance is stronger and more positive for risk than time-based forward guidance like the ‘temporary asymmetric operational inflation target range' discussed at the January meeting. The idea is to accept inflation moving above the 2% target to make up for a period with inflation below 2%.
Overall, we expect the Fed to implement a mix of yield curve control and an average inflation target at its September meeting. We believe the Fed recognises the drawbacks of a stand-alone yield curve control policy. We consider some sort of average inflation targeting as better for risk than yield curve control policy.
Information on these pages contains forward-looking statements that involve risks and uncertainties. Markets and instruments profiled on this page are for informational purposes only and should not in any way come across as a recommendation to buy or sell in these assets. You should do your own thorough research before making any investment decisions. FXStreet does not in any way guarantee that this information is free from mistakes, errors, or material misstatements. It also does not guarantee that this information is of a timely nature. Investing in Open Markets involves a great deal of risk, including the loss of all or a portion of your investment, as well as emotional distress. All risks, losses and costs associated with investing, including total loss of principal, are your responsibility. The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of FXStreet nor its advertisers.