Monday, November 11, 2013

Fed Mandate and the 2014 US Economy

The economic recovery is soggy, as some would put it. Growth is idling along, unemployment is above long-term averages but on a downward trajectory, and inflation is looking to remain tepid for the foreseeable future. Equities appear over-bought by some metrics, and so do bonds because of a manipulated yield curve.

With this economic environment, what can we expect of a Yellen Fed?

As the labor markets continue to digest the longer-term effects of the 2008 recession, the unemployment rate continues to meander lower. From the standpoint of the Fed, half of their mandate (the unemployment part) is sorting itself out, the other half (the inflation part) never really got off the bench. Basically, we’re getting to the point where there is nothing for the Fed to do, and if there’s nothing for them to do, I think they will just keep doing what they’ve been doing, which is monetary easing.

If growth doesn’t pick up in any significant way, in spite of unemployment converging with the natural rate, and the specter of inflation being nowhere to be found, I think a monetarist Fed would have no problem with maintaining an accommodative policy.

When unemployment hits the explicit targets set by the Fed, which should be a signal to start unwinding the current monetary policy, they are more likely to lower their unemployment benchmark to continue supporting growth, instead of taking steps towards limiting access to liquidity in the financial markets.

Without a jump in inflation (and soon) the US could be facing dare I say, a deflationary cycle and the prospect of a liquidity trap.