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.

Download The Full Fed Monitor

Share: Analysis feed

This publication has been prepared by Danske Bank for information purposes only. It is not an offer or solicitation of any offer to purchase or sell any financial instrument. Whilst reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and no liability is accepted for any loss arising from reliance on it. Danske Bank, its affiliates or staff, may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives), of any issuer mentioned herein. Danske Bank's research analysts are not permitted to invest in securities under coverage in their research sector.
This publication is not intended for private customers in the UK or any person in the US. Danske Bank A/S is regulated by the FSA for the conduct of designated investment business in the UK and is a member of the London Stock Exchange.
Copyright () Danske Bank A/S. All rights reserved. This publication is protected by copyright and may not be reproduced in whole or in part without permission.