The Planning Of Monetary Policy Normalization By The Federal Reserve

by Stephan Smith on October 9, 2014

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During the September 16th and 17th (2014) Federal Open Market Committee meeting in Washington DC, the Federal Open Market Committee (FOMC) discussed plans on how to best normalize monetary policy. Such talks suggests the FOMC is anticipating improvement in the United State economy to such a degree, that it would merit a policy stance similar to polices prior to the 2007-2008 financial crisis. A very encouraging sign.

It is important to note that the FOMC does not believe the United States economy is at a stage where monetary policy normalization procedures can commence. In fact, the Minutes of the Federal Open Market Committee for September 16-17 2014 have made it very clear that the Federal Reserve does not believe now is the time for such actions. The FOMC merely feels that now is the time to talk about the plans for returning monetary policy back to normalcy.

Participants agreed that it was appropriate at this time to provide additional information regarding their approach to normalization. – Page 3 of the Minutes of the Federal Open Market Committee 9/16-17

The discussions were part of prudent planning and do not imply that normalization will necessarily begin soon. – Page 3 of the Minutes of the Federal Open Market Committee 9/16-17

Actions The Federal Reserve Plans To Take To Return Its Monetary Policy Back To Normalcy

So once economic conditions meet the FOMC’s criteria, what does the Federal Reserve plan to do in order to normalize its polices? Though its current policy stance is accommodative and expansionary, it won’t be forever, especially if inflation projections start to break through the 2% target.

According to the minutes of the Federal Open Market Committee, once the committee has determined it is appropriate to start normalizing policies, it will start raising the federal funds rate to a more normal level. Currently, as of 10/8/2014, the federal funds rate is at 0 – 0.25% – a highly accommodative stance. When this increase will happen is yet to be seen.

The Federal Reserve will also gradually reduce its holdings of securities. Such a policy will shrink the Federal Reserve‘s balance sheet and remove dollars from the system; monetary tightening. This policy will only occur after the federal funds rate has increased. The Federal Reserve will also revert to primarily holding Treasury securities.

Of course, all these policy changes are subject to change at anytime.

United States Dollar Under Normalization

Once policy normalization efforts are implemented, I do foresee the potential for the United States dollar to strengthen considerably relative to other currencies. That potential will only be realized depending on two factors; the intensity at which normalization procedures are implemented and the monetary policy direction of other central banks. In a prefect storm, the sleeping giant that is the United States dollar will rise if normalization efforts are intensive and other central banks remain loose on policy. Gains in valuation will be undeniable.

If the inverse occurs and policy normalization is weak and lackadaisical, while other central banks lean more toward monetary tightening, the United States dollar will increase in value slightly, if at all relative to other currencies. We will just have to wait and see.

At the current moment, the United States dollar has gained valuation vs other currencies. When compared to the euro, the dollar has gained more than 10 cents. The currency quote for eur/usd currency pair went from $1.3994 in May 2014 to as low as $1.2512 in October 2014. That’s an appreciation of 14 cents in only 6 months. The causes for such an appreciation can stem from the anticipation of the Federal Reserve normalizing policies, to the economic turmoil being experienced by Europe.

A weekly chart of the eur/usd.

A weekly chart of the eur/usd as of 10/8/2014

The United States dollar has also gained against the Japanese yen. When compared by the same six months, it took as much as ten more yen to get one United States dollar. The dollar is strengthening, but may weaken over time. That depends on when normalization of the Federal Reserve’s monetary policies is enacted and the overall growth of other countries.

A weekly chart of the usd/jpy as of 10/8/2014

A weekly chart of the usd/jpy as of 10/8/2014

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