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.
Author
Danske Research Team
Danske Bank A/S
Research is part of Danske Bank Markets and operate as Danske Bank's research department. The department monitors financial markets and economic trends of relevance to Danske Bank Markets and its clients.
