SM Market Perspectives JANUARY 2013

2013 outlook: Low rates and a possible change at the top

With any interest rate hike off the table, Federal Reserve (Fed) watchers will be left to focus on two issues in 2013: the future of the Fed’s bond buying program and the likely successors to Fed Chairman if, as many believe, he does not return to the Fed helm when his term expires in January 2014.

The low down Although Bernanke would be the most prominent dove, among the more notable policy doves is Chicago Fed President The Fed’s Federal Open Market Committee (FOMC) has Charles Evans, who has for some time supported linking Fed definitely sent the market some mixed signals. The FOMC policy directly to specific economic data instead of relying announced after its December meeting that the Fed would be on subjective decisions. That idea, which some have started making $85 billion in monthly asset purchases for an indefinite calling the “Evans Rule,” was instituted at the FOMC’s period, effectively expanding a third round of quantitative easing December 2012 meeting. (QE3) launched earlier in 2012. The Fed also appeared to leave the door open to additional moves, suggesting that further Under the rule – the first such policy guidelines in the easing could be forthcoming “if the outlook for the labor market Fed’s 100-year history – the FOMC has said it will hold its key does not improve substantially.” Fed funds rate at the current historic low of 0 to 0.25% “at least as long as:” But when the minutes of the closed-door meeting were later made available, they revealed that “several” Fed officials said • Unemployment remains above 6½% ; they expect the Fed will slow or stop the bond purchases “well before the end of 2013.” According to the minutes, the Fed • Inflation between one and two years ahead is projected to policymakers are concerned about financial stability and the be no more than a half percentage point above the FOMC’s size of the Fed’s swollen balance sheet. At its current pace, the 2% longer-run goal; Fed’s bond buying program would add about $1 trillion to the • Longer-term inflation expectations continue to be Fed balance sheet in 2013 if it continues through the end of the well anchored. year. Although the comments did not relate to the Fed’s interest rate policy, the statements marked the first FOMC signal that it Although the change is significant in terms of Fed’s policy will eventually look to tighten its exceptionally loose monetary communication, Bernanke said that the criteria did not imply any policy stance. adjustments to recent policymaker views about the likely future policy path. Fed officials currently believe the newly-announced How it unfolds will hinge on the economy and particularly conditions for policy firming are unlikely to be met until 2015, unemployment – which FOMC members expect to improve according to Fed survey data. relatively little this year – and potential inflationary pressure. Among this year’s Fed policy voters, jobs are clearly the most 2013 Federal Open Market Committee Meeting Schedule important issue. January 29-30 Ten of the 12 voters in 2013 fall into so-called “dove” camp, March 19-20* or those who generally see monetary policy’s primary mission as providing the fuel for economic growth – job creation in the April/May 30-01 current environment. The alternative viewpoint comes from June 18-19* the “hawks” who view monetary policy’s primary goal as price July 30-31 stability – particularly containing inflation. Among the 2013 Fed voters there are two probable hawks: Kansas City Fed President September 17-18* Esther George, a first-time Fed voter whose views align closely October 29-30 with her predecessor, inflation hawk and current FDIC vice- chairman Thomas Hoenig; and James Bullard, the St. Louis Fed December 17-18* president who has questioned the concept that monetary policy *Meeting associated with Bernanke press conference and release of is an effective tool for job creation. Fed economic projections. Market Perspectives JANUARY 2013

Changing chairs? Beyond policy, a possible reshuffling of Fed leadership could Other potential names that may emerge as possible also make headlines later in 2013. Reports prior to the 2012 appointments by President Obama to succeed Bernanke include presidential election indicated that Bernanke, who began his Alan Krueger, chairman of Obama’s Council of Economic tenure as Fed chairman in 2006, may not want to serve another Advisors, former Clinton Treasury Secretary Lawrence Summers, term after his current term expires on Jan. 31, 2014. The markets and current Treasury Secretary Timothy Geithner. will likely begin to expect some kind of announcement from the White House, either about Bernanke’s return or the nomination of a successor, at the end of the summer or early fall. 2013 Federal Open Market Committee voting members

The speculation about the next Fed chairman, however, has Ben Bernanke, chairman already begun. Among current Fed officials, the front runner appears to be current Federal Reserve Vice Chairman Janet Elizabeth Duke, governor Yellen. Yellen, who would be the first female Fed chair, is already , governor seen as being highly influential in forming the Fed’s policy views and is believed to have played a key role in the recent Fed Sarah Bloom Raskin, governor decision to state specific inflation and unemployment targets. Her Fed resume is also lengthy. Prior to her appointment to vice Jeremy Stein, governor chair in 2010 she was president of the San Francisco Fed for six years, and served a stint on the Fed’s Board of Governors during Daniel Tarullo, governor the Clinton administration in the mid-1990s. She later chaired , governor Clinton’s Council of Economic Advisors. James Bullard, president, of St. Louis From a specific policy perspective, Yellen is seen as among the most dovish of all the Fed’s senior officials. In a November 2012 William Dudley, president, Federal Reserve Bank of New York speech Yellen laid out a Fed policy path that recommended the Fed hold its key interest rate at current levels into 2016 Charles Evans, president, Federal Reserve Bank of Chicago and below 1% until 2017. Yellen said the path, which is below what most currently expect from the Fed, would foster stronger Esther George, president, Federal Reserve Bank of Kansas City employment growth, with the tradeoff being inflation slightly Eric Rosengren, president, Federal Reserve Bank of Boston higher than the Fed’s 2% target starting in 2014 and continuing through 2018.

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