Then there is the vexing question of what
the Fed will do if and when inflation hits its two
per cent target. Will it apply the monetary brakes,
wait to see if infation settles into a comfortable
range, or have a noisy argument?
All three possibilities pose distinct challenges for investors.
A second key indicator to watch is the slope
of the yield curve. Both US and European yield
curves are expected to steepen and if they do
they will probably be a non-issue.
The economy generally does well in a steeper yield curve
environment because it suggests monetary policy
is accommodative. The concern is what it means
if the yield curve continues to flatten. When the
yield curve becomes completely flat or inverts, a
recession often follows because monetary
policymakers have pushed short rates too high.
This scenario could easily occur if the Fed
keeps raising the Fed Funds rate each quarter
even if inflation moves only slowly if at all towards
its two per cent target.
The Fed may lead itself into such a situation because the economy seems
strong enough to withstand higher rates, and
because the Fed is anxious to raise rates enough
to offer capacity to cut in a future recession
without hitting the zero lower bound again. It
would be ironic if its efforts to do so were to bring
on a recession before it reached escape velocity.