Optimal Control

Earlier this week, the Senate held confirmation hearings for Janet Yellen who is set to take over as chairman of the Federal Reserve when Ben Bernanke’s term expires in January. While we do not anticipate major policy shifts under Yellen’s leadership we do think there will be some changes, particularly in the language used to describe the policy approach.

For the past several months, the key buzzwords related to the Fed have been Quantitative Easing (QE) and tapering. As we move forward, we expect the emphasis to shift to phrases like “optimal control” and “low rates for longer.” We also believe QE’s pace is likely to at least be tempered in the next few months. Any change in the Fed’s current stance will continue to be data dependent as they have indicated.

In a series of speeches last year, Yellen outlined her “optimal control” approach to monetary policymaking. It starts with an economic forecast and uses a macroeconomic model to determine how to set short-term interest rates in way that enables it to meet long-term targets for annual inflation (2%) and the economy’s natural unemployment rate of 6%.

Using this balanced approach, the optimal policy would likely keep the federal funds rate close to zero until early 2016, about two quarters longer than currently expected. As a result, one possible outcome of an optimal control strategy would be a more aggressive stance toward fighting above-target unemployment, implying lower short-term rates for longer.

We note that while previous comments from Ms. Yellen indicate her support for optimal control, it is not a certainty that it will be the Fed’s approach under her leadership. Against this backdrop, we continue to believe it is a stock picker’s market and diligently search for individual securities with the potential to deliver strong long-term returns at attractive prices.