At this week’s inaugural quarterly Fed press conference, Chairman Bernanke was asked when the Fomc were going to tighten monetary policy.  This question naturally arises now that we are nearing the end of QE2.  Ben replied that the Fomc would tighten policy if rising inflation became a concern to them; although jobs are being created and the unemployment rate is heading lower, he stressed that the US economy is “digging itself out of a very deep hole” with more than 7 million new jobs required.  With the Fomc itself forecasting an unemployment rate of 7% by the end of 2013, the Fed Funds rate is going to remain at an “exceptionally low level for an extended period”.

However nothing lasts for ever and eventually the Fed will begin to raise rates.  The last time the Fed was in this position was in 2004 after Greenspan had kept rates below 1.25% for 18 months.  Once Greenspan began a rate-hiking cycle, he raised rates by 25bps at every single FOMC meeting until he handed over the Chair to Bernanke in Feb 2006 with rates at a neutral policy level of 4.5%.

The future course of the economy will determine how quickly the Fed raises rates and how high they raise them before they once again go on hold to see how things pan out.  Given that unemployment has thus far only fallen from a high of 10.1% to 8.8%, it is likely that the Fed will want to keep stimulating the economy into creating jobs as we are nowhere near the 5.5% unemployment rate that the Fed regards as neutral (Bernanke also clarified the Fed’s inflation target range as being 1.7% to 2% during this week’s press conference).  Once QE2 finishes at the end of June 2011, the first step the Fed will take towards tightening monetary policy will be to stop re-investing the principal payments on their stock of bonds purchased under QE1 and QE2.  This is the lowest-risk way for the Fed to signal tighter policy and it will allow them to see how the markets react before taking the more formal step of removing the “exceptionally low level for an extended period” language from the official Fomc statement.

The FOMC members have made it clear in the official minutes of their meetings that “the Committee’s expectation for policy was explicitly contingent on the evolution of the economy rather than on the passage of any fixed amount of calendar time. Consequently, such forward guidance would not limit the Committee’s ability to commence monetary policy tightening promptly if evidence suggested that economic activity was accelerating markedly or underlying inflation was rising notably; conversely, the duration of the extended period prior to policy firming might last for quite some time and could even increase if the economic outlook worsened appreciably or if trend inflation appeared to be declining further.”  In plain English –  ”Exceptionally low rates for an extended period” means until the unemployment rate comes down sharply or inflation takes off.

The Fed is trying to perform a delicate balancing act here.  Bernanke made clear they don’t want to start QE3 because rising commodity prices have caused inflation to spike above their 1.7% to 2.0% target range.  But they do want the economy to keep growing and creating jobs.  Having had the pedal pressed fully against the metal since Jan 2009, they are now going to ease up on the accelerator (by ending QE2) but they don’t want to tap the brakes because unemployment is nowhere near 5.5% and they believe inflation is still under control.  Economists will debate for decades whether QE1 and QE2 really worked but we are more interested in trying to successfully navigate around the markets once the Fed starts tightening monetary policy.

Central banking is an art not a science and this is why the answer to the question “where is the Fed Funds rate going once tightening begins” is not “3.5% by July 2013″ but rather “upwards until the unemployment rate stabilises”.