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Putting theory into practice

Like the Reserve Bank of Australia, the US Federal Reserve has a dual mandate to control consumer prices and encourage employment. The Fed’s next chairman, Janet Yellen, is well known as an evangelist for jobs growth which is perhaps what the US economy really does need right now.

The diminutive stature of Ms Yellen belies her intellectual pedigree. She is a Yale-qualified economist who studied and taught at Harvard University before entering public office at both the Federal Reserve and the White House Council of Economic Advisors and the OECD in a sparkling career.

Her inclination is to continue with the easy monetary policy settings to allow the unemployment rate to fall to 6.5% (or better) without letting inflation get too far above the Fed’s 2% target.

It’s not insignificant that her initial statements begin with talk of jobs before mentioning inflation.

She will inherit a position where global markets will be looking for three distinct moments of communication:

  1. The point in time at which the Fed will reduce the amount of monthly bond purchases it makes – the so-called tapering.
  2. The point in time when the Fed believes employment growth has become robust enough to sustain economic growth and;
  3. Further down the track, the point in time when ‘near-zero’ interest rates will no longer be necessary.

Yellen’s job will be littered with all manner of booby traps such as the US government’s budget bloopers. Even international events could play a part in how and when the Fed communicates its strategy so it will not be a smooth path.

The markets will of course interpret anything and everything that emanates from the Fed as there has been precious little fiscal leadership so far in the recovery.

One of the conundrums the market must grapple with is the initial tapering move. The Fed has so far struggled to convince the market that tapering is not tightening. Instead, it will be a sign that the economy is improving, requiring less monetary stimulus, while at the same time emphasising that interest rates remain at historic lows.

Ben Bernanke’s time as a two-term chairman hasn’t ended yet, but the market will be hanging off every utterance from Ms Yellen.

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