FOMC Seeks to Talk a Good Game
Switching to qualitative guidance on rates frees Fed from numerical constraints but poses other challenges.
Watch what they say, not what they do.
The Federal Reserve's policy-setting Open Market Committee will wind up a two-day meeting Wednesday, when it is expected to describe the conditions under which it will begin to raise short-term interest rates from the floor, where they have been pinned since the credit crisis in late 2008.
Those words will count far more than the actions to come out of the confab, which will be to taper further the central bank's buying of Treasury and agency mortgage-backed securities. The panel is all but certain to approve another $10 billion reduction in its monthly purchases from the current $65 billion pace. Fed officials have set a very high bar to deviate from that path.
But the FOMC has boxed itself into something of a corner as to when and under what conditions the FOMC will lift its federal funds target, from 0-0.25%.
From March 2009 until June 2011, the panel said it would keep the fed funds rate near zero for an "extended period." In October 2012, FOMC tried to get more specific, putting policy on a calendar by stating the funds rate would stay near zero until mid-2015.
In December of that year, it made that conditional upon the unemployment rate falling to 6.5%, from 7.8% at the time. With the jobless rate down to 6.7% in February, in large part because of lower labor-force participation, that parameter is increasingly problematic.
Various Fed officials, from Chair Janet Yellen on down, have emphasized the headline unemployment rate understates the slack in the labor market. Thus, she doesn't want to be constrained by that flawed measure.
That's especially so if inflation is running well below the Fed's 2% target, as it has been consistently for some time. Indeed, Yellen has provided hints that she would not be averse to maintaining an easy policy in the face of positive indicators—such as falling unemployment—if inflation remains in check.
In an out-of-print volume, The Fabulous Decade: Macroeconomic Lessons from the 1990s, co-authored with former Fed Vice Chairman Alan Blinder published in 2001, Yellen wrote one of the reasons for the success of the previous decade was the willingness of the Fed (then led by Alan Greenspan) to forego interest-rate hikes then. Inflation appeared to remain well in check, despite the fall in the jobless rate; surging productivity from technology was paying off, according to the authors' thesis. Greenspan opted not to raise rates until he saw "the whites of the eyes" of inflation.
Fast forward almost 20 years and the jobless rate again is falling faster than expected but inflation remains in check. Numerous economists, both inside the Fed and outside, agree the headline unemployment rate understates the actual slack in the labor market, especially given the degree of dropouts from the workforce.
Thus the Fed has the choice of changing the policy parameters for a rate hike: a lower jobless rate threshold; more attention to a too-low inflation rate; some attention to financial-market indicators, which show easy conditions, especially in the credit markets; or some form of qualitative guidance.
The latter would be analogous to the Supreme Court's definition of obscenity. The FOMC can't define in advance the conditions under which it would raise its rate target, but it will know when it gets there.
JPMorgan Chase economists think the latter option is most likely, rather than changing numerical thresholds.
"We believe that this switch will be done with an intent to convey no change in the stance of policy, much like Indiana Jones replacing the golden idol with a bag of sand," they write.
"The Fed pulled a similar switcheroo back in December 2012, when it transitioned from calendar guidance to threshold guidance, but as [former Federal Reserve Chairman Ben Bernanke] noted at the time, 'this change in the form of the Committee's forward guidance does not in itself imply any change in the Committee's expectations about the likely future path of the federal funds rate'."
Bottom line: The Fed doesn't want to be constrained by a preset number.
Fed watchers also will be examining the chart of various FOMC members' expectations for the timing of the initial fed funds hike. These charts representing the personal view of each of the seven members of the Fed's Board of Governors and the 12 Fed district bank presidents. (All the Fed governors vote on the FOMC along with five of the Fed presidents, who serve on a rotating basis, except for New York, which always votes.)
In the previous set of projections, released Dec. 18, two members thought the first hike could come in 2014 while the consensus—12 members—thought it would happen in 2015. The other three looked for the first increase not to come until 2016. It would not be surprising if the expectations of a 2014 rate increase are eliminated in the new polling.
Looking at the dots representing the anticipated year-end fed funds targets, 10 expected the rate to be 1% or less by the end of 2015 and 10 looked for it to be 2% or less by the end of 2016.
That would be well below what the panel's members reckon to be the normal, longer-run fed funds rate—around 4%, according to the consensus.
The FOMC's task will be to communicate how it gets from here (near zero interest rates) to there over those time frames. Too much specificity can backfire.
The Bank for International Settlements, the so-called central bank for central banks, recently warned that signaling that short-term rates will remain low for a long period can encourage destabilizing, speculative excesses. Think of how the glacial pace of fed funds hikes from very low levels in the mid-2000s helped to inflate the housing bubble.
By contrast, the quick rise in the fed funds rate—from 3% to 6%—in 1994-95 sent shock waves through the stock market—roiling the mortgage-backed securities market, which wound up bankrupting Orange County, Calif., and rippled through to Mexico's "Tequila crisis" in which the peso crashed.
While Yellen and Blinder praised the Fed's actions then in producing a "soft landing" for the U.S. economy, the Fed has taken pains to avoid such disruptive side-effects, although not successfully, as the events of 2007-08 show.
That's the conundrum the FOMC faces: how to signal its plan to lift rates from near zero without roiling the markets and causing a back-up in interest rates that could throttle the expansion, while not encouraging a new bubble
