We all want to know how long the current economic expansion will last. It’s been a long and lackluster recovery since the financial crisis ended, and we all want to be prepared for when the economy slows. That is why we all watch the economic data, listen to central banks and generally look for hints. It’s a little like the game of Clue.
Clue, as you remember, is a board game where players try to figure out the three main facts of a murder: the murderer, the location of the murder, and the murder weapon. They accomplish this by having their characters run around a mansion gathering evidence. At SNW we are all trying to figure out who will murder this economic expansion, where the crime will be committed and what murder weapon will be used.
Last week Yellen offered clues to the answers for all three of the game’s questions. The murder weapon will likely be either tapering of the Fed’s balance sheet or gradually increasing interest rates. The murderer should be the Federal Reserve, as it is the first major central bank to begin meaningfully removing monetary accommodation, and the location could be the Fed’s headquarters at the Eccles Building on 20th Street NW, Washington D.C., between C Street and Constitution Avenue, to be specific.
Yellen announced last week the Fed will begin to shrink its balance sheet starting in October 2017. At first the reduction will be relatively modest at $10 billion a month, but the tapering steps up quarterly to $50 billion a month by October 2018. This is real money. Yet the Fed’s balance sheet is $4.5 trillion, and even at $50 billion monthly, tapering will take time. The Fed also wants to increase the Fed funds rate over time, and by its projections the rate will be 2.5%-3.5% by the end of 2020. The next rate increase may come in December 2017, and the Fed could see its way to three rate increases in 2018. While this does not look like a murderous schedule, it does appear unhealthy in light of what the Fed expects to be slower GPD growth, higher unemployment and still quite low inflation.
At this time we are still early in the game. There are many more moves to make and the Fed is not always the best forecaster, as we know. Inflation has undershot the Fed’s target for the last five years! Adding to this uncertainty the President could replace Yellen next year. As we see it, balance sheet tapering and the normalization of interest rates could take far longer than anyone anticipates. But what we do know is that some strong clues were disclosed last week.Source: The Federal Reserve, The Financial Times, Bloomberg