Well, one thing is certain in the wake of the market reaction to Federal Reserve Chair Janet Yellen’s first press conference yesterday: forward guidance policy works, just not necessarily in the way intended.
The media and market seized on the six month remark, ignoring the long list of caveats that followed in Yellen’s lengthy answer to a question on how long a gap there might be between the end of the taper and when rate hikes begin.
But as we rather strongly suspect there will be a fair degree of messaging re-set by Fed officials starting as early as tomorrow when a number of Federal Open Market Committee members are slated to give speeches:
*** First, the six months was clearly not the intended main takeaway from the press conference and especially the statement. The accent ahead from Fed officials is certain to focus on the emphasis in the statement that no policy change is intended in the new post-threshold guidance, that rates will remain exceptionally low and amply accommodative, that the first lift-off in rates remains data-driven and forecast-dependent, and that both the trajectory and end point to the tightening is likely to be below the normal levels in past cycles. ***
*** It is not that the Fed is likely to backpedal from the six month time frame from the end of the taper; after all, if the recovery did quicken with growth, employment, and inflation all improving a little more quickly than forecast, then the first rate hike would be adjusted accordingly. But that is not the base case scenario, but one of multiple scenarios under the new qualitative guidance framework. In particular, among the caveats cited by Chair Yellen in her response that was lost in the blur of the six month remark, the Fed will be especially watching for any risk in the persistence of low inflation under its 2% medium term target. ***
“Shacking Up” with Higher Rates
The front end of the rates market re-priced pretty aggressively after yesterday’s FOMC meeting, with a fixation of sorts on an April 2015 first rate hike, that is, the “six months” being taken from an October meeting to end the taper altogether. More importantly perhaps, as we noted briefly yesterday afternoon (SGH 3/19/14, “Fed: Believe What You Read, Not What You See”), there is a certain psychological shift underway in how the upcoming data will be taken, namely, any stronger data will indeed be taken that much further and more aggressively as validation of the new six month theme now lodged in the mindset of expectations.
And there is a view that if the FOMC collectively moved up their year-end fed funds rate projections in yesterday’s Summary of Economic Projections up amid the current, lingering weather-related data uncertainty, Lord only knows how much higher they will be moving them up by the June meeting if the data do improve by then?
The new market zeitgeist, if not re-framed a bit, could also mean that if the Open Market Desk should soon increase the rate of the reverse repo in its trials to 5 to 10 basis points from the current 1 bp to 5 bp any time soon when the effective fed funds rate is 8 basis points, the market will tend to take it as yet another sign of a tightening.
One piece of good news at least is that while the front end is being aggressively repriced, the longer end has not spiked up as much as might be expected, certainly nothing like the market reaction to last May, for instance. Perhaps it is because the statement’s inclusion of the sentence that rates will remain “below the levels the Committee views as normal in the longer run” is already sinking in.
“It Just Depends”
In any case, the Fed may have it work cut out for itself over the course of the next few days and weeks to re-frame expectations by dialing back to how the “six months” is only one of multiple scenarios in a data-dependent policy path going forward.
That is, rather than dismiss the six months, Fed officials may steer in a way that suggests that while yes, it is certainly possible under a best case scenario of very positive growth, employment and inflation numbers, it is not necessarily the base case scenario envisioned at present.
Policy is very much data-driven and forecast dependent, and that six months could just as easily be anywhere from nine, or twelve longer after the taper ends. As Yellen said with a shrug, “it just depends.”
In particular, especially from the more dovish-leaning Committee members, there is likely to be an accenting of how the risk of low inflation that persists for longer than expected under its 2% medium term target will be a key factor in the calculations going into the timing on the lift-off in rates.
And not to belabor the point (too much), but Fed officials could also still argue that even with the upward drift in the dots guidance on 2015 and 2016 year-end rates, they are still indicating a more dovish messaging than the steeper trajectory under a “normal,” more traditional Taylor Rule assumption, something we also highlighted was possible if not likely some time ago (SGH 1/10/14, “Fed: Goodhart’s Law and the Thresholds”).
So it seems likely to us Fed officials will be pressing over the next few days and weeks to re-frame expectations and to get its messaging back on track. With that in mind, Chair Yellen’s upcoming speech in mid-April before the Economic Club of New York as we noted previously (SGH 3/12/14, “Fed: Equilibrium and the Next Phase of Guidance”) is likely to provide an ideal moment to make a lasting re-set to market expectations.
And lastly, we would rather suspect the Fed will be revamping the SEP and the dots format sooner rather than later.
Introduced in January 2012 as a bit of an opportunistic way to anchor expectations, essentially as greater transparency in an extension of the forecasts, the dot-plots have since hardened into a closely followed tool of the forward guidance in a way they were never intended to be. We highlighted the potential dilemma of the dots problem in early January (see SGH 1/22/14, “Fed: Towards a Post-Threshold Framework”), and Yellen herself went out of her way to practically diss the dots altogether as a reliable guide.