Yellen Speaks, Do the Financial Markets Listen?

No surprise, the Federal Open Market Committee tapered the monthly rate of asset purchases by another $10 billion and altered the language in its forward guidance on the federal funds rate. In its policy statement, the FOMC indicated that “it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends.” Moreover, the FOMC expects that conditions will warrant a below-normal level of the overnight lending rate even as employment and inflation near the Fed’s goals. As the FOMC statement noted, none of this reflects any change in the Fed’s policy intentions.

Former Fed Chair Ben Bernanke was exceptionally clear, but financial market participants often had a hard time understanding what he had to say. Janet Yellen was expected to be even clearer in her descriptions of the economy and monetary policy. Yet, there is a lot of nuance. For example, asked about the expected time between the end of QE3 and the first hike in short-term interest rates, Yellen responded:

“So, the language that we use in the statement is ‘considerable period.’ So, I, you know, this is the kind of term, it's hard to define. But, you know, probably means something on the order of around six months or that type of thing. But, you know, it depends on what the statement is saying and it depends on what conditions are like. We need to see where the labor market is -- how close are we to our full employment goal – that will be a complicated assessment not just based on a single statistic – and how rapidly are we moving toward it. Are we really close and moving fast? Or are we getting closer but moving very slowly? And then, what the statement emphasizes and this is the same language we used in December and January; we used the language ‘especially if inflation is running below our 2% objective.’ Inflation matters here, too, and our general principle tries to capture that notion. If we have a substantial shortfall in inflation – if inflation is persistently running below our 2% objective – that is a very good reason to hold the funds rate at its present range for longer.

A bit rambly, to be sure (especially given the unedited false starts and “you knows”). She’s clearly thinking on the fly. However, her answer suggests that she and other Fed officials have spent a lot of time thinking about how monetary policy might evolve. The clear answer is that “it depends.” If the economic recovery proceeds as anticipated, inflation begins to move toward the 2% goal, and financial conditions remain stable, then the asset purchase program will end in 4Q14 and the first increase in the federal funds rate would likely come in 2Q15 (in April or in June). However, there are a lot of moving parts here. Yellen recognizes that monetary policy affects the economy with a lag and that the Fed has to be vigilant against putting too much inflation in the pipeline. However, that’s not a big concern right now. There’s also a danger for the economy if inflation continues to trend too low.

Fed officials expect that inflation will move gradually toward the 2% goal, but if not, the first rate hike would be pushed out.

While the markets have focused primarily on the trajectory of Fed asset purchases, the forward guidance on the overnight lending rate is just as important. In December 2012, the FOMC moved from a time-based directive to an economic directive. The establishment of thresholds for the unemployment rate (6.5%) and inflation (2.5%) was meant to give the financial markets more insight into how the Fed will determine the path of monetary policy. However, with inflation nearing the 6.5% threshold, this proved problematic. The Fed has now shifted back to a qualitative directive. That gives the Fed more flexibility, but it also has potential to add to market uncertainty. What constitutes sufficient improvement in the job market? What level of inflation is too low? The Fed has indicated that in determining how long to maintain the current 0-0.25% range for federal funds target it “will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.” This may bring to mind Supreme Court Justice Potter Stewart’s definition of pornography – “I know it when I see it.” Monetary policy is set by a committee and different Fed officials have different opinions about the degree of slack in the economy.

At the March policy meeting, the four Fed governors and 12 district bank presidents submitted updated projections of growth, unemployment, and inflation. While weather has been a factor behind recent softness in the economy, the outlook for the year as a whole hasn’t changed since December.

Fed officials also submitted projections of the federal funds rate. Only one expected a rate hike this year. All but two expected to raise rates sometime in 2015, but there was a wide range of views regarding exactly how much. More importantly, most expected below-normal rates at the end of 2016.

© Raymond James

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