Fed Playbook, 2014 Game Plan All Set for Yellen

By MarketsFOXBusiness

With the playbook already written and the 2014 game plan in place, Janet Yellen is poised to become quarterback of the U.S. economy.

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On Monday, the full Senate is scheduled to vote on Yellen’s nomination to succeed Federal Reserve Chairman Ben Bernanke as head of the central bank. Her approval needs a simple majority of the Senate’s 100 members and she is expected to easily surpass that.

The playbook for the coming year basically consists of one play: scaling back, or tapering, the Fed’s monthly bond purchases, a program known as quantitative easing.

The game plan will depend on the economy. If the data continue to steadily strengthen, the Fed, as it announced last month, will gradually taper its asset purchases at intervals of $10 billion a month until the program expires later this year.

The playbook seems fairly rigid. The Fed in 2013 had telegraphed for months its intention to start scaling back its easy-money policies through a gradual tapering because that method would have the least impact on the broader economy. Raising the key fed fund interest rate is still off the table for the foreseeable future.

“The imbalances that caused the recession have corrected themselves. What that means is that the economy is strong enough to continue to expand even with the tapering.”

Gus Faucher, economist PNC Financial Services Group

The game plan needs to be flexible, however, capable of shifting in accordance with data from key sectors such as labor, housing and manufacturing. So if labor markets dramatically improve or decline, the Fed can adjust its tapering policy on the fly, increasing or decreasing the rate at which it moves away from quantitative easing.

Careful, Cautious, Measured Fed Policy

“It’s going to be a very careful Fed policy,” said Cliff Waldman, a senior economist for the Manufacturers Alliance for Productivity and Innovation (MAPI), a public policy and economics research organization in Arlington, Va.

Waldman predicted that the first year of tapering, which will coincide with Yellen’s first year as Fed chair, will be “cautious and measured.”

“We are in unchartered waters,” he said. “The Fed did during this crisis what it didn’t do during the Great Depression, and that’s a good thing. But there’s zero historical precedent for what’s going on and we’re still in a post-crisis world. The Fed realizes there are still landmines out there.”

Rising interest rates, an inevitable result of tapering, probably won’t have much impact on large U.S. manufacturers such as IBM (NYSE:IBM), Parker-Hannifin (NYSE:PH), Ingersoll-Rand (NYSE:IR) and Sauer–Danfoss (NYSE:SHS), Waldman explained.

Big, multi-national companies aren’t likely to see their borrowing costs rise very much, he said, because they’ve already established solid credit track records. Smaller manufacturers – and small businesses as a whole – will feel more of an impact because its riskier for banks to loan them money.

Most forecasters believe the U.S. economy will continue to slowly gain momentum in 2014, which will allow a Yellen-led Fed to stick to the playbook established in late 2013 under Bernanke.

Broad Fundamentals Solid

Gus Faucher, an economist with PNC Financial Services Group, said broad economic fundamentals -- consumer balance sheets, corporate profitability, government finances --  have solidified in recent years and should follow that trend in 2014.

“The imbalances that caused the recession have corrected themselves. What that means is that the economy is strong enough to continue to expand even with the tapering,” Faucher said.

Tapering’s impact on the housing sector should prove something of a double-edged sword. On the one hand, reducing the Fed’s monthly bond purchases of Treasuries and mortgage-backed securities will force mortgage rates higher. That could push some prospective buyers out of the market and decrease overall home sales.

That might not be such a bad thing, however. The most recent S&P Case-Shiller home price index for October rose by nearly 14% year-over-year, the largest gain since the collapse of the U.S. housing market in 2008 and stoking concerns of another bubble.

Faucher said that rate isn’t sustainable and that higher mortgage rates “will take a little steam out of the price growth.” He’s predicting a year-over-year home price increase of about 5% between now and 2015.

“That’s a sustainable pace, roughly in pace with income growth,” Faucher said. “Housing won’t become unaffordable, we won’t see a bubble.”

Instead of tapering having an impact on labor markets and job growth, it will be the other way around, said Greg McBride, senior financial analyst at Bankrate.com.

Increased Stock Market Volatility

In other words, if job growth accelerates and the headline unemployment rate falls sharply the Fed might consider accelerating its tapering program. Conversely, if labor markets hit another rough patch the Fed could slow the pace of tapering.

McBride sees stock market volatility spiking with tapering. All of the major stock indexes have soared for five years under the Fed’s easy-money policies. The Dow Jones Industrial average and broader S&P 500 index have both surpassed levels achieved prior to the 2008 financial crisis and both ended 2013 at record highs.

McBride doesn’t see that upward trajectory ending. Indeed, he believes stocks will end higher in 2015 than they began this year. He just sees stocks zigzagging more often as traders respond to the beginning-of-the-end of easy money.

“I think the market will end higher than it started but it will be a bumpy ride,” McBride said. “The market is going to have to recalibrate from the impetus of easy money and return to a focus on fundamentals, namely top line revenue growth and profit growth.”

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