Our takeaways from today’s trifecta of the Federal Open Market Committee statement, the always problematic “dots guidance” of the Summary of Economic Projections and Chair Janet Yellen’s first press conference are threefold:
*** First we were a wee surprised how unmistakably dovish the formal statement was in replacing the Numerical Threshold guidance with the descriptive, potentially more vague, qualitative language. In particular, the explicit inclusion of the assumption of a lower equilibrium interest rate stood out, with all that it implies for a more gradual rate trajectory and lower terminal point. The second was just how hard Yellen practically pleaded to take the more hawkish-looking “dot plot” with a grain of salt. ***
*** Third, for all the concerns the Fed’s guidance could become too vague, Chair Yellen went the other way, articulating an explicit guidance that the “considerable period” rates will be held at current levels after the bond purchases end “probably means something to the order of six months, that type of thing.” Even with the usual caveats that it depends on “what conditions are like at the time,” and whether intended or not, the chair of the FOMC crossed a psychological “threshold” of sorts for many in the markets, strongly pointing to a lift-off from the zero lower bound at its May or probably June 2015 meeting. ***
Chair Yellen hit all the very dovish messaging talking points, and indeed, many FOMC members have already cited the second half of 2015 as the likely timeframe for a lift-off in rates, and former Chair Ben Bernanke has in the past defined the phrase “considerable period” as six months more or less. In this current context however, when the market was pricing in perfection and a very dovish Yellen, she in effect just literally confirmed the lift off is being penciled in for the middle of 2015. It is an eerie echo of Bernanke’s own premature messaging on the taper. It is as though the psychological front edge of the market has swung round from the reasons for why the rate rise can be held off in the lower for longer scenario to a new framework that the lift off is now on the horizon.
“Below normal in the longer run”
Easily the most important change in the FOMC’s post-threshold forward guidance was the inclusion of the sentence explicitly affirming that “even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”
In other words, the assumed neutral or equilibrium rate is lower than the widely assumed 4%, meaning the Fed will be taking the rate tightening on a flatter, more gradual trajectory once the first rate is finally underway (see SGH 3/12/14, “Fed: Equilibrium and the Next Phase of Guidance”).
That this made it into the formal statement is impressive, and represents a victory of sorts for those Committee members, most probably including Chair Yellen, who wanted the post-threshold guidance to remain unmistakably dovish on the appropriate policy path.
There were apparent trade-offs however. The doves failed to keep some form of the 2.5% inflation threshold in the statement that has suggested a tolerance for overshooting the 2% medium term inflation target if need be, or references to concerns over the persistence of low inflation. But with unemployment now projected to move more quickly towards trend than the December projections, perhaps there is no longer a need to risk an overshoot of the inflation target.
Nevertheless, its absence was probably what irked Minneapolis Fed President Narayana Kocherlakota enough to warrant a dissent, a dissent that by the way, most of the Committee will find reinforcing rather than undermining the core dovish takeaway intended. More telling, was the absence of a dissent (or two) from the hawkish side.
Those Problematic Dots
Of course, it would seem the markets immediately reacted not to the very dovish statement, but to the upward drift of year-end fed funds rate projections in 2015 and 2016 in the accompanying Summary of Economic Projections. In both years, the visually dovish cluster of the projected year-end levels rose to a 1% median in 2015 from around 0.75% in the December projections and up to 2.25% at the end of 2016 from well under 2%, more like 1.75%, last December.
But two points. The first, in an echo of the confusion last June, Chair Yellen essentially pleaded that the SEP “dots” are not the primary forward policy guidance, but rather the (voted) statement is; so between the two, believe what you read not what you see. In other words, as Chair Yellen put it, “I really don’t think that it is appropriate to read too much into [the movement of the dots].”
Secondly, and more importantly, even under an optimal control framework the trade-off of faster employment growth for possible and temporary inflation later narrows as the economy nears trend levels, and essentially eliminates the need to risk an overshoot of inflation; the level of accommodation will modestly lessen and the projections for the appropriate policy path will rise on a slightly higher trajectory, but is still far lower than it would be under the traditional Taylor Rule assumptions, that is, below “normal” levels in the longer run (see SGH 02/12/14, “Fed: The Bullard Takeaways”).
We would stress that the new post-threshold guidance will still be evolving over the next few meetings rather than as a one and done change in March. The most important change that may come, if a consensus can be hammered out, is a revamp to the SEPs, not to mention the revisions to the June 2011 Exit Principles.
The latter may have to come sooner rather than later now that there has been a “six month” time frame put to the post QE “considerable period,” which will undoubtedly put the Exit and balance sheet management to the forefront. More than anything else, today reminded us that central bank policy guidance remains far more an art than a science, and live press conferences can potentially be tricky, even in the best of circumstances.