Eoin Treacy's view -
So I want to make clear that our inflation objective is two percent and we’re projecting a move back to two percent. And we are not trying to engineer an overshoot of inflation, not to compensate for past undershoots…with a continuing improvement in the labor market, I think we’ll see upward pressure on inflation. And in that context, the committee sees it appropriate to, if things unfold in that way, to have some further increases in the federal funds rate. – March 16 2016
Tightening to prevent inflation from reaching or surpassing 2% has the risk of hindering the continuation of the beautiful deleveraging. Containing inflation creates the risk of rising real yields in a low-rate environment and reduces the ability to work through the debt overhand. And if such moves were more significant than current pricing, the hit to asset prices would also create a risk of a renewed downturn that is difficult to manage. As the chart below shows, the current Fed forecast implies further tightening before the end of the year and continued tightening in the years following, at a rate faster than what is currently expected by the market. Were the fed to tighten in line with their median forecast, assets prices would fall as discount rates increased, and the wealth of holders would take a hit. As we’ve discussed in previous Observations, this would be particularly dangerous, as there is limited ability to ease if the resulting tightening pushes the economy into self-reinforcing contraction.
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The Fed printed a lot of Dollars to soak up the issuance of Treasuries and mortgage bonds that resulted from the bailout from the credit crisis. Having ceased purchasing bonds quite what it is going to do with its holdings when they mature is still very much an open question. Since early 2015 the Fed has been rolling over its holdings as they mature, but last year had very few maturities.
Rolling over is likely to be a greater challenge in the years ahead because they need to manage the maturity of over $200 billion this year, a little less than that in 2017 but over $350 billion in 2018 and over $300 billion in 2019. That’s a big question because the funding cost for the interest on that debt is going to rise if the Fed is simultaneously raising interest rates.
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