YELLEN’S TESTIMONY

Janet Yellen, Chairwoman of the US Federal Reserve (Fed) addressed the House Financial Services Committee on Wednesday in her bi-annual testimony on the state of the US economy and monetary policy. In her speech, she signalled that the Fed would take a cautious approach to tightening monetary policy in the face of an uncertain inflation outlook and said the Fed would continue to raise interest rates gradually to a “normalised” level. Although, if inflation weakness persisted they could amend the strategy.

In Yellen’s speech, she was positive on the US economy. The US job market has been strengthening, there has been a rebound in household spending and inflation is expected to rise towards the Federal Reserve’s 2% target. However, despite the global economy improving, economic challenges remain.

Investors’ attention was focused on whether there was any indication that further interest rate hikes were likely this year. Yellen referenced that the Fed will continue to use interest rates as its primary policy tool and noted that many of her colleagues thought one further rate increase would be warranted this year. However, she insisted it was “premature” to second guess policymakers.

Inflation is one of the key considerations in the formulation of monetary policy.  “We are watching inflation very carefully” Ms Yellen said in response to questioning from lawmakers. “I do believe part of the weakness in inflation reflects transitory factors but well recognise that inflation has been running under our 2% objective and that there could be more going on there”.

US Inflation and Interest Rates

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Source: Bloomberg, 14 July 2017

Markets welcomed Yellen’s dovish comments and the S&P 500 rose 0.3%, with the Dow Jones Industrial Average closing at a record high. On the bond markets, the yield on the benchmark 10-year Treasury slid 4 basis points to 2.32% with investors hoping that the Fed’s easy money stance will remain for longer given the evident uncertainty about the outlook for inflation and the economy in general.

FED’S $4.5 TRILLION BALANCE SHEET

Beginning in late 2008 the Federal Reserve (Fed) began the wide scale assets purchasing programme to clean up the balance sheets of most financial institutions that had taken on the toxic mortgage backed securities. This programme is now better known as quantitative easing (QE) and prevented financial markets grinding to a halt.

The effect of QE was to reduce interest rates to record lows and so encourage lending to spur growth. QE ended in late 2014 but since then the Fed has done little to reduce the size of its swollen balance sheet. As Treasury bonds that the Fed has bought have matured, they have been replaced and so the stock of bonds the Treasury is holding as a result of QE has remained constant at around $4.5trn.

Minutes from recent Fed meetings have revealed the desire to begin reducing the balance sheet towards the end of 2017, effectively selling back in to the market some of the bonds it has bought or at least not replacing those bonds that mature. Now the plan is clear, the Fed will start tapering $6bn a month in maturing Treasuries, which will increase by $6bn every 3-months over a 12-month period until it reaches $30bn per month. Alongside this it will be tapering $4bn a month in mortgage backed securities until it reaches $20bn.

Fed’s Balance Sheet

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Source: Bloomberg, 14 July 2017

Despite the certainty of method, the timing of the implementation is still up for debate. However, the gradual introduction of the policy will hopefully smooth out any impact of the initiative and, given, the gigantic size of the balance sheet it is likely to take many months for the reduction to have a noticeable effect on financial markets.

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