Meet the New (FOMC) Boss


Federal Reserve

The selection of Federal Reserve Chairman Ben Bernanke's replacement has the media pundits buzzing over who will get the nod. No one knows for certain and probably not even yet the one person who gets to decide, President Obama. For investors the question becomes, "Does it matter?" Our answer is unequivocally, "yes."

To appreciate why the choice of the next Chairman of the Federal Reserve matters is to appreciate the historically unprecedented division within the Fed today. Things have changed markedly since the "old days of financial repression " when the Federal Open Market Committee (FOMC) would simply peg interest rates for US Treasury securities. There were no press conferences or questions about quantitative easing or "tapering." But that was a wartime Fed.

Today's bond prices (and yields) are set by central bankers in a different way, through forward guidance of low rates for "a considerable time" and a willingness to use an unlimited balance sheet to "do whatever it takes." This brings us back to why the choice of who will be the next Chairman is so important . At the moment, the battle within the Fed boils down to a fundamental disagreement over whether it should be more accommodative or less.

From past statements, the two leading candidates for Fed Chairman, Larry Summers and Janet Yellen, have vastly differing viewpoints on the costs and benefits of unconventional monetary policy such as quantitative easing . The general perception left through all of the dissection of their past comments is that Summers is more hawkish than Yellen . The differences between these positions as well as how each would weigh the opinions of a deeply divided committee undermine market confidence. That loss of confidence is manifest in the recent rise in interest rate uncertainty particularly concentrated in short-dated maturities - precisely the area that would be most impacted by shifting expectations over Fed policy.

Such uncertainty appears so far to have escaped the stock market, but we would expect that to change if expectations for the next Chairman-and the policies they were likely to employ-become unanchored (see Figure 1 below).

Bond vs. Stock Market Uncertainty

The new Chairman of the Federal Reserve will start his or her term in January of next year. Based upon the likely (rumored) choices, the path for policy could be consistent with the easing bias of the recent past… or go the other way. The outcome is critical to bondholders.

What of the Latest from the FOMC?

July's FOMC statement was not a big market mover, though following the stronger-than expected GDP report , bond markets saw greater volatility. The Fed statement reaffirmed what Chairman Bernanke has discussed in his recent communications -- namely, that the Fed's economic forecasts expect economic growth to pick up. While the statement also upgraded the concern of too little inflation, the committee reiterated their view that they expect that challenge to be temporary.

Still, while the GDP report was stronger than expected, it showed a very low level of overall growth in the economy. Such economic performance, even if moving in the right direction, limits the scope for how quickly the Fed can remove its policy accommodation. Interest rates appear well on their way to higher levels, but the persistent slow pace of economic growth is limiting how fast those rates can go up.

Jeffrey Rosenberg, Managing Director, is BlackRock's Chief Investment Strategist for Fixed Income, and a regular contributor to The Blog.  You can find more of his posts here.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

This article appears in: Investing , Economy

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