One of the key events of last week (and there were plenty) was the Fed’s decision and what Janet Yellen said in her press conference. Yellen shed some light (significant, I would say) about the Fed’s thought process towards the ‘normalization’ of monetary policy. Markets expected this information during the Jackson Hole meeting at the end of August, but it just came last week.

Normalization of monetary policy is clearly the key topic for the Fed, and we believe and have argued many times it is one of the key topics for the markets. The Fed has massaged expectations gradually over the last few months, as much that the market has switched from wondering when and how ‘normalization’ would happen to a mindset of ‘we are in the normalization process’. Beyond the details of timing and tools to be used, we believe the key take away from last week is that the Fed is focused on normalization, managing the process, and that it will be done gradually and with care. In other words, it is no longer a question of when and how, but only how fast and what is the sequence of events.

The debate and reporting about Fed’s policy is extensive and can get to be quite technical and elaborate. But there is only so much we can say that is original and of relevance for portfolio construction at the moment. Here we focus on a few simple ideas.

Tapering is done soon (most likely in October), so the next move would be the first rate hike. It will obviously depend on how the economy evolves. We believe it will be sooner than the market expects, and not only because of the economy improving more rapidly than what markets expect. The Federal Reserve system has produced recently a couple of research papers that clearly indicate how they are thinking about the labor markets, showing that the lower participation rate is more structural than cyclical. This means the Fed sees labor markets as getting tight sooner than what markets expect. Thus, the first hike could be around the second quarter of 2015.

The balance sheet will not shrink fast. Yellen explained that they would at some point stop re-investing the cash flows produced by the assets in the balance sheet, but that would happen later, and most likely very slowly. She also said the balance sheet is unlikely to converge back to the pre-crisis size.

There were other relevant but somewhat more technical issues she clarified. The important concept we take away from last week is that the process will be very gradual, that the Fed cares about the market reaction, and that the pace of economic expansion is obviously a key determinant. Hikes would most likely start sooner than expected. We believe the Fed attitude and approach is relevant in a continuation of the current scenario, of mediocre growth. If the economy were to accelerate and grow somewhat consistently in the 3-4%, then growth takes care of the Fed and markets are less likely to be spooked (except if the Fed becomes very aggressive). In the scenario in which growth falters back to the low 1% area, then the Fed is likely to refrain from normalization. The scenario in which we remain focused on the Fed actions and thought process is the scenario in which growth remains significantly below potential, but inflation continues to gradually converge to its historical average or beyond.