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The challenge facing the Fed

By Martin Harvey, fixed income fund manager at Threadneedle Investments

Despite increased optimism at the start of the year, growth forecasts for the US economy are once again falling towards the 2% trend pace of recent years. The faster-than-anticipated fall in unemployment appears to betray a fall in the economy’s potential rate of growth. To put this another way, the output gap has been closing faster than might have been expected, thus posing a challenge to US monetary policymakers, particularly as accommodative monetary policy is based on the assumption of a meaningful output gap. For its part, the consensus expects another $10 billion taper tomorrow, spread across mortgages and Treasuries.

The Fed has described itself as data-dependent and the faster-than-anticipated fall in unemployment should reveal something about its reaction function this week. If the Fed truly is data dependent we would expect it to raise rate guidance and accompany this with some somewhat more hawkish commentary at the press conference. However, given that annual GDP forecasts are also likely to be revised down, and other labour market measures such as wage growth remain subdued, Chairwoman Janet Yellen may again try to calm market participants’ fears of rate increases. In this case, we would anticipate steeper government yield curves and further support to risk assets.

The Fed is also likely to debate the principles of its eventual exit from QE, providing a contrast with Europe where the ECB has recently been forced to unveil a series of extraordinary policy measures, which has led to speculation that the ECB could implement some form of QE later this year.

Source : threadneedle.com

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