Fewer things are more important to Federal Reserve policymakers than clear communication to financial markets about their interest rate intentions. Between now and when the Fed’s rate-setting Federal Open Market Committee (FOMC) starts raising the federal funds rate from near zero, Chair Janet Yellen and her colleagues will use every opportunity to prepare markets.
The plan is to use FOMC statements, the quarterly Summary of Economic Projections (SEP) and Yellen’s press conferences, Congressional testimony and speeches to make sure markets are in synch with the Fed to the extent possible. Fed officials are under no illusion all market volatility can be avoided, but would like to minimize it. No more “tantrums,” please.
The task is large, given the gap between FOMC assessments of appropriate funds rate levels — the “dots”— and market expectations. Until very recently, markets were fully pricing in only one 25-basis-point increase by December. Meanwhile, the dots pointed to two.
FOMC participants continually have revised down their funds rate, along with their economic projections. For instance, in the March SEP, their median assessment for the end of 2015 was 0.625% — down from 1.13% in December and from 1.375% in September. There were comparable markdowns for subsequent years.
The expected funds rate for the end of 2017, 3.125%, was well below the estimated longer run (or equilibrium) rate of 3.75%; in keeping with Yellen’s pledge to keep the funds rate “below normal” and the pace of rate hikes “gradual.”
Yet, markets have continued to project an even shallower rate path, although the strong May employment report raised odds of a September lift-off and perhaps a second 2015 hike.
Still, divergences continue.
Policymakers’ essential aim in all their communications will be to update markets continually on how they think the economy is doing relative to the two conditions for starting to raise the funds rate, which the FOMC has set forth since abandoning time-based forward guidance in March. Namely, further improvement in labor markets and becoming “reasonably confident” inflation is headed toward 2% “over the medium-term.”
If Yellen et al. are to avoid surprising markets and generating excessive volatility after 6.5 years at the zero lower bound, they must see to it markets are reading the economic data the way they are.
Their hope is that the data will speak for itself.
As New York Federal Reserve Bank President William Dudley puts it, “Because the conditions necessary for lift-off are well-specified, market participants should be able to think right along with policymakers, adjusting their views about the prospects for normalization in response to the incoming data.”
“This implies that lift-off should not be a big surprise when it finally occurs, which should help mitigate the degree of market turbulence engendered by lift-off,” he says wishfully.
Effective Fed communication, it is hoped, will enable the FOMC to convey to markets regularly the progress (or lack thereof) the economy is making toward meeting those two conditions for starting monetary normalization.
Yellen took a big step in that direction in late May when she said the economy is “well positioned for continued growth” and said, “If the economy continues to improve as I expect, it will be appropriate at some point this year to take the initial step to raise the federal funds rate target.”
She even sounded close to being “reasonably confident,” saying, “I believe that consumer price inflation will move up to 2% as the economy strengthens further and as other temporary factors weighing on inflation recede.”
Officials are letting it be known real GDP growth around 2.5% would be deemed consistent with achieving the FOMC’s stated objectives of further labor market improvement and reasonable confidence on inflation.
But many agree with Vice Chairman Stanley Fisher who calls himself “a firm believer that the employment data are better than the output data,” i.e., jobs numbers trump unreliable GDP estimates.
Policymakers want to give clear indications about how they think the economy is measuring up to those two conditions so that, by the time of lift-off, it is obvious the time has come.
St. Louis Federal Reserve Bank President James Bullard, for example, says he “would like to move on the back of good news. It’s very difficult to say you are going to normalize things just when the economy looks a little weak.”
Officials know they won’t be able to prepare the markets fully, however. The predominant FOMC mood is to make its best efforts to signal its intentions — then let the chips fall where they may.