Interest Rates at their Scariest: What You Can Do About It
NEW YORK ( TheStreet) -- Uncertainty over how the Federal Reserve plans to unwind its unprecedented monetary policy has created a tricky environment for interest rates over the next 12 months or longer.
Given the enormity of the Fed's bond buying over the past 14 months, it's terribly unclear how the gargantuan task of trimming the Fed's balance sheet will actually be carried out.
The critics say move carefully, but what does that mean? Move too fast, and the Federal Reserve risks hurting the recovery. Move too slowly, and the Fed risks higher inflation. In either outcome, the central bank could be forced to readjust its tapering pace with little warning, risking the provocation of interest rate volatility and increasing unpredictability in the stock, bond and currency markets.
There's just no telling from which direction the Fed could adjust its taper because in practice, the Fed's monetary policy stance will likely be more reactive than planned in the coming months.
Roger Aliaga-Diaz, the Philadelphia-based senior economist at mutual fund giant Vanguard Group , says he's comfortable estimating that interest rate volatility may be higher than normal in 2014. Malvern, Pa.-based Vanguard Group manages $2 trillion in U.S. and international investments.
"We're in uncharted territory," said Aliaga-Diaz during an interview with TheStreet on Jan. 10. "Not even the Fed knows what it is going to do next. They don't know it. They're looking at the same information that we are looking at. They are taking the decisions as the information comes in, and they are going to respond to those changes on the spot, which means that trying to time the market is really a useless exercise."
Indeed, the central bank itself, even with its economic research staff of more than 450 economists, has been thrown for a loop on the economic outlook as the labor force pool continues to shrink despite leading indicators such as manufacturing activity signaling continued expansion; the latest government job report showed roughly 400,000 people dropping out of the labor force in December against job gains of merely 74,000. For quite some time, the Fed had thought that as the economy improved, there'd be a pickup in the number of Americans returning to the labor market. But on many occasions, economic data has been counterintuitive.
Further adding to rate agitation risks is the possibility that the markets may have more and more trouble distinguishing between tapering and tightening as new economic forecasts come in.
In trying to walk a fine line, the central bank will likely continue to opt for a conservative, $10 billion a month bond tapering until it can extract and confirm longer-term trends from the volatile, monthly government job report, said Aliaga-Diaz.
The Fed will also keep an eye on wage pressures. Aliaga-Diaz says that a wage increase of 3% to 4% annually, from 1.9% in the third quarter, could signify the beginnings of a tightening labor market preceding increasing inflation.