2016 or Bust: When Will the Fed Tighten Policy?

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As manager of the Total Return Fund (one of the world’s largest mutual funds), PIMCO co-Founder and co-CIO Bill Gross has a unique perspective on economic and business conditions. Gross is widely regarded as one of the best bond investors on the planet, and is highly vocal about — and sometimes critical of — policy that affects the economic backdrop against which he makes investment decisions.

Most recently, this would be the accomodative monetary policy that has been fostered under U.S. Federal Reserve Chairman Ben Bernanke. The Total Return Fund is the world’s biggest bond fund, and between May and June increased the share of U.S. government debt in its portfolio from 37 to 38 percent. Yields on the 10-year T-note increased from about 1.64 percent to 2.16 percent in May, increased further to about 2.48 percent in June, and hit a recent peak of 2.73 percent in early July.

At a glance, this increase is a function of “taper talk,” or Fed communication about the eventual taper of asset purchases and even more distant tightening of policy, as well as the market conversation surrounding it.

At a press conference following the June monetary policy meeting, Bernanke suggested that if Fed projections hold true over the next six to 12 months, the Fed could begin tapering purchases by the end of 2013, and end the program altogether sometime in 2014. It’s important to point out that this is by all means an estimate, and the Fed has emphasized time and again that its policy decisions will depend on incoming data.

While the Fed has made its economic forecasts clear, Mr. Market still reacted to the comments by driving the yield on the 10-year T-note from less than 2.20 percent to more than 2.41 percent in about 24 hours. Gross was quick to suggest that the market may be reacting incorrectly to Bernanke’s statements.

Shortly after the press conference, he told Bloomberg that “Those who are selling treasuries in anticipation that the Fed will ease out of the market might be disappointed unless we have inflation close to 2 percent.” As indicated, the key ingredient here is inflation.

“I think the Chairman is almost deathly afraid, and we have witnessed in speeches going back five or 10 years on the part of the chairman in terms of the helicopter speech and the reference not only to the depression but to the lost decades in Japan. I think he is deathly afraid of deflation,” he continued.

So when will the Fed tighten policy? The first thing to point out is a statement that the Fed has repeated in several separate communications over the past few months.

From the July Monetary Policy Report: “The Chairman also drew a strong distinction between the asset purchase program and the forward guidance regarding the target for the federal funds rate, noting that the Committee anticipates that there will be a considerable period between the end of asset purchases and the time when it becomes appropriate to increase the target for the federal funds rate.”

In other words: tapering first, tightening later. Gross sees tightening in 2016 at the earliest. Meanwhile, Fed committee participants “saw increases in the target for the federal funds rate as being quite far in the future, with most expecting the first increase to occur in 2015 or 2016,” according to the report.

FOMC Policy

Here’s how the main U.S. indexes traded on Monday:

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