Yellen Loses "Patience," But Maintains Flexibility

The Federal Reserve is no longer committed to being “patient” before it starts raising rates. In Fed-speak, that means it will actively consider raising rates starting in two meetings, which will be in mid-June.

However, a June rate hike is not a fait accompli. Fed Chief Yellen appears to have bent over backward to make sure the Fed’s doves don’t feel like they’re being railroaded into supporting a rate hike at that meeting.

For example, the Fed reduced its projection for the unemployment rate over the long run to about 5.1%, which is about 0.25 percentage points below what it projected only three months ago. That change is important because the Fed’s economic models say a lower unemployment rate relative to the long-run average translates into higher inflation. So, by cutting the long-term average, the unemployment rate can go lower before the Fed’s models signal higher inflation.

In addition, there were some notable changes to the “dot matrix” showing where Fed policymakers think interest rates will go over the next few years. Back in December, the dots showed the median policymaker at the Fed thought short-term rates would rise 100 basis points this year and 125 – 150 bp in 2016. Now the median dots suggest rate hikes of only 50 bp this year and 125 bp next year.

Yellen herself appears to have participated in the downgrade of rate-hike expectations. There are 17 participants at the meeting and she is probably on the dovish side. So, with the highest dot being the most hawkish, we’re guessing Yellen is probably around dot number 12. Back in December, that dot suggested an increase of 75 bp this year and 125 bp next year. Now that same dot suggests 50 bp this year and 100 bp next year.

However, we would not read too much into these changes. Yellen is going to great lengths to make sure the extreme doves at the Fed – the ones who would prefer to go all year without a rate hike – feel like they’re being heard. Recent data on retail sales, manufacturing output, and home building have all been weak, so the Fed has room to recognize a moderation in the pace of economic growth. Our models suggest real GDP growth is tracking an annualized pace of 1% in Q1 and we bet the Fed’s models are showing something similar. But, like last year, we expect the pace of growth to bounce back rapidly by mid-year.

Ultimately, the Fed’s statement today was about being dependent on the data. We suspect Yellen understands a pick-up in growth is likely, just like last year, and by that time she will have the chance to alter her forecast, as will the others at the Fed. And, having recognized recent weakness at today’s meeting, she’ll have a better chance to get the more extreme doves to acknowledge a re-acceleration in growth by June.

The bottom line is that, although we’re not quite as confident as we previously were, we still think the Fed is on track to start raising rates in June. Nominal GDP – real GDP growth plus inflation – is up 3.6% in the past year and up at a 4.1% annual rate in the past two years. A federal funds target rate of nearly zero is too low given this growth. It’s also too low given well-tailored policy tools like the Taylor Rule.

Either way, once the Fed eventually raises rates, it’s unlikely to raise rates at every meeting, as was done in the past two prolonged rate hike cycles under Alan Greenspan in the late 1990s and Ben Bernanke in the middle of the prior decade. Instead, the Fed will probably raise rates at every other meeting for the first year, before embarking on a more aggressive path in the second half of 2016 and beyond.

This information contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Haver Analytics. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy.

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