The primary policy tool of the Fed

The Fed's monetary policy has important implications for the bond, stock, and currency markets, and the economic cycle generally. In this report my goal is to track the data that I think Fed officials, and Chair Powell specifically, are most focused on based on ongoing public communications.

 

Fed's Dual Mandate

Established Objectives of Federal Reserve Monetary Policy:

Stable Prices ("Price Stability"): 2 percent inflation rate as measured by the annual change in the price index for personal consumption expenditures (Headline PCE YoY). The Powell Fed views the core (excluding food and energy) PCE as a better indication of future inflation. It is worth noting that the Fed interprets the inflation objective as symmetric, meaning they are trying to prevent persistent deviations, either above or below, from their 2 percent inflation target.

Maximum Employment: The highest utilization of labor resources that is sustainable over time, i.e., the unemployment rate that is consistent with low and stable inflation over the longer term- often estimated as the "natural rate of unemployment." The natural rate of unemployment comprises both the "frictional" unemployment of people who are temporarily between jobs or searching as they have reentered the labor force and the more "structural" unemployment of people whose skills or physical location are not a good match for the jobs available. In other words, the Fed aims to reduce "cyclical" unemployment. As Powell likes to point out, the unemployment rate that is consistent with maximum employment is largely determined by nonmonetary factors (i.e., not heavily influenced by Fed policy). The Fed has no fixed goal for this rate, the current longer run estimate for unemployment is 4.4%, from Fed's Summary of Economic Projections.

 

Fed Policy Tools

Federal Funds Rate: the primary policy tool of the Fed, it is the overnight benchmark interest rate. The Powell Fed aims for this rate to be at the estimated normal longer-run level when the policy objectives are met (i.e., when inflation is running at the target rate of 2% and the economy is operating at maximum employment).

Fed Balance Sheet: Quantitative Easing ("QE") is Fed balance sheet expansion via bond purchases using "printed money," Quantitative Tightening ("QT") is essentially the opposite, i.e., Fed balance sheet contraction via allowing bonds to mature without reinvesting the proceeds.

Forward Guidance: a commitment to hold rates at a certain level (e.g., zero) over a certain period of time.

 

Fed Key Concepts

Data Dependency: The Fed describes its policy making process as data dependent, which might be best summarized by Chair Powell's words: "Our views about appropriate monetary policy in the months and years ahead will be informed by incoming economic data and the evolving outlook. If the outlook changes, so too will monetary policy." Many of the following charts represent the relevant data followed by the Fed, and specifically by Chair Powell.

 

Fed Funds Rate

Fund funds rate (black) and Fed estimate (based on median dot) of normal longer run rate (grey)

Analysis: Powell is patiently waiting for economic data to come in to determine the next move in interest rates. Specifically, the Fed is concerned about the potential for continued muted inflation.

Download The Full Merk Investments