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Federal Open Market Committee : Don 't Forget The Balance Sheet

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Fed Policy in 2017: Don’t Forget the Balance Sheet
Throughout last year, the media were solely focussed on the differences of opinion on the Federal Open Market Committee (FOMC) between the doves and hawks as being solely about the projected increase in the federal funds rate. The baseline outlook proposed by Chair Yellen was for a glacial trajectory, but this was always subject to alteration depending on the underlying tone of incoming economic data. Since the financial crisis, however, US monetary policy has been underpinned by two separate pillars: 1) asset purchases, and 2) a zero-bound federal funds rate. Divisions of opinion between hawks and doves were evident before the onset of tapering asset purchases in 2014, and they
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It was, however, also legitimate to ask whether the Fed was jumping the gun. Currently, the economy is arguably at full employment and short-term interest rates are being normalised, albeit gradually. The economic circumstances are, therefore, somewhat different to 2013. The policy of the Fed towards ending reinvestment of maturing principle will be dictated by economic outcomes, the same factors as to what will drive interest rate normalisation. Investors may worry that Fed will make a mistake in trying to readjust the two pillars underpinning US monetary policy simultaneously and, commensurately, increase the risks of tightening too quickly. The FOMC will, therefore, closely monitor the behaviour of bond yields during 2017. Should yields spike and financial conditions tighten then thoughts of balance sheet normalisation will be quickly shelved. Additionally, the performance of yields will be affected by supply-demand factors, including increased Treasury securities issuance to finance tax cuts and higher spending, thereby potentially putting the Fed in a tight spot. Chair Yellen will not wish to convey the idea that, as a major player in the government bond market, the Fed is bankrolling fiscal policy easing by continuing the reinvestment of maturing principle. Rising bond yields under fiscal policy easing could, however, raise mortgage rates that could upend the housing market.
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