"The exit has begun,” as incoming Federal Reserve vice chairman Stanley Fischer says, but the Fed is only part-way down the exit ramp, and beyond lies a long, uncertain road toward monetary policy “normalization.”
What’s more, the signposts along the way may not always be so easy to read. Notwithstanding repeated pledges by Chairwoman Janet Yellen and her fellow policymakers to communicate clearly, the public and financial markets are unsure of the Fed’s signals.
In fairness, communication has been clear enough, at least since December, about unwinding the Fed’s third round of large-scale asset purchases.
On March 19, the Fed’s policymaking Federal Open Market Committee reduced purchases of longer-term Treasury and agency mortgage backed securities by $10 billion per month for a third straight meeting—true to its stated intention to reduce bond buying in “measured steps” so long as the economy was performing as expected.
Yellen, in her first post-FOMC press conference, projected that tapering of asset purchases would be completed this fall. But beyond the end of quantitative easing, as we contemplate actual monetary tightening, things get murkier.
For the third time in less than a year and a half and the sixth time in five years, the FOMC changed its “forward guidance” on the path of the federal funds rate—not exactly a record of continuity in the quest for transparency. Following a series of moving calendar dates for “lift-off” of the funds rate, the FOMC adopted numerical thresholds in December 2012, saying it would not consider raising rates as long as the unemployment rate was above 6.5% and projected inflation was not over 2.5%.
Faced with a situation in which the headline unemployment rate had fallen to within a hairs breadth of that threshold, the FOMC amended its guidance in December 2013 to say it would likely keep the funds rate near zero “well past” 6.5%. Then in March it abandoned quantitative forward guidance altogether and adopted “qualitative” language.
Now, the FOMC says, “in determining how long to maintain the current 0-0.25% target range for the federal funds rate, the Committee will assess progress—both realized and expected— toward its objectives of maximum employment and 2% inflation” taking into account an array of labor, inflation and financial gauges.
For now, it says, “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, especially if projected inflation continues to run below the Committee’s 2% longer-run goal, and provided that longer-term inflation expectations remain well anchored.”
The obvious question for Yellen was what does “a considerable time mean,” to which she responded “around six months.”
A little quick figuring seemed to imply that if QE3 ends in October, initial rate hikes could come as early as next Spring, maybe as soon as April. Wall Street was displeased. So in late March, Yellen revised her remarks at a Community Reinvestment Act conference. She could have confined herself to Fed enforcement of CRA requirements that banks provide credit to low income neighborhoods. Instead, she sought to reassure everyone the Fed is in no hurry to raise rates, citing the plight of individual job seekers.
The Fed can and should “provide substantial help to the labor market, without adding to the risks of inflation,” because “there remains considerable slack in the economy and the labor market” and few wage pressures have emerged, she said, adding that “labor conditions are worse than indicated by the unemployment rate. [The Fed has made] an unprecedentedly large and sustained commitment ... to do what is necessary to help our nation recover from the Great Recession,” said Yellen, adding, “This extraordinary commitment is still needed and will be for some time....”
In this new communication era, Atlanta Federal Reserve Bank President Dennis Lockhart advises that forward guidance will require “more interpretation,” not just of FOMC statements but of comments by the Fed Chair and other policymakers. In another nuance, looking beyond lift-off, the FOMC declared, “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.”
Sure enough, when the appropriate rate assumptions of the 16 FOMC participants (the “dots”) are compared with their economic projections, a wide disparity leaps out. Officials project that above-trend growth will reduce unemployment to 5.2% from 5.6% and raise inflation from 1.7% to 2.0% by the end of 2016, in line with their longer-run forecasts. Yet their assessments of the “appropriate” funds rate are far below their consensus on the “equilibrium” funds rate.
Ten of 16 FOMC participants estimated the “longer-run” funds rate to be at least 4%. But the median forecast of where the funds rate ought to be at the end of 2016 is just 2.25%.
As Yellen put it in her press conference, the funds rate is “unlikely to be back to normal levels for some time.”
The FOMC may go with the latest iteration of its forward guidance for a considerable time, but don’t count on it.