Beyond employment: the other possible challenges for the Fed

Highlights:

• In the forthcoming meeting on Wednesday, the Fed will stick to its narrative focused on the need to keep an accommodative stance, as the labour market has still to improve substantially.
• However, the Fed might at some point need to use some flexibility in its balance sheet to tackle some emerging risks. First, the sizeable rise in long term interest rates may slow down growth the recovery; secondly, the looming large shift of cash from the Treasury account at the Fed to the banking system, would increase the downward pressure on short rates.
• So far, the increase in long term interest rates has not triggered a tightening in financial conditions, as the rise has not spilled over to other parts of the financial market. Should this happen, we expect the Fed to react by twisting its bond holdings towards longer maturities, possibly combined with maturity extension of the purchases. Outright yield curve control appears a rather extreme measure.
• Moreover, the Fed will have to decide on whether to extend the temporary measures on the supplementary leverage ratio, expiring at the end of the month. Maintaining the exclusion of reserves and Treasuries from the leverage computation would ease the burden of the banking sector and the Treasury market alike.

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