A flashing exit sign from the Fed

A turning point in the Federal Reserve’s discussions provides yet another type of forward guidance, and marks an important moment in the path to recovery.

The Federal Reserve has turned its attention to its exit strategy, with widespread debate at its April meeting regarding the best approach for raising rates in an environment where banks have trillions of dollars in excess reserves.

Although the minutes noted that these discussions “did not imply that normalisation would necessary begin sometime soon”, the discussions indicate a firm shift in the Fed’s focus.

Participants at the meeting generally agreed that beginning the discussions now would help the Committee formulate the best plan and communicate this plan to the public well before it needs to implement it.

Effectively the Fed is aiming to provide yet another type of forward guidance. Though no decisions were formally made during the meeting, participants “agreed that it would be helpful to continue to review these issues at upcoming meetings”.

Since the Fed has never previously attempted to raise rates with such an extensive balance sheet, most participants at the meeting thought it should “consider a range of options and be prepared to adjust the mix of its policy tools as warranted”.

Needless to say that with attention shifting to raising rates and its exit strategy, the Fed will continue to wind back its asset purchases at upcoming meetings. But if recent comments are any indication the Fed is likely to continue reinvestment of its asset earnings until after it begins to raise rates.

Fed vice chairman William Dudley noted that there will be “a considerable period of time” between the end of its asset purchases and the Fed raising rates. Current projections suggest that rates might begin to rise in around mid-2015.

The US economy appears to have recovered following a weather-effected start to the year. Despite soft GDP growth in the March quarter, the labour market has continued to strengthen – albeit slowly – and there is tentative evidence that inflationary pressures are beginning to build.

Graph for A flashing exit sign from the Fed

The main area of concern for the US is its housing sector, with residential investment taking a further hit in the March quarter. Though this partially reflects the weather, housing permits for single-family homes – which are less sensitive to fluctuations in weather – remain below their level in the December quarter.

“Readings on housing activity – a sector that has been recovering since 2011 – have remained disappointing so far this year and will bear watching,” Fed chairwoman Janet Yellen said earlier this month. “The recent flattening out in housing activity could prove more protracted than currently expected rather than resuming its earlier pace of recovery.”

Besides housing the greatest near-term risks appear to be international. A further slowdown in China would certainly weigh on growth globally and a further increase in geopolitical tensions regarding Russia and Ukraine could create risk aversion through financial markets.

But overall the outlook for the US economy remains fairly bright, having bounced back following a poor start to the year. Nevertheless, there remains considerable spare capacity across the US and until wages begin to pick up and measures of inflation follow suit the Fed will be happy to leave rates unchanged.

The discussion of an exit strategy marks another important moment on the path to recovery. Growth both in the US and globally depends on an orderly transition for the Fed and it cannot afford another misstep such as that which caused the ‘taper tantrum’ throughout financial markets last year.

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