Is monetary policy an art or a science?
Many central bankers and analysts prefer to emphasize the latter. If central bankers can measure the degree of slack or tightness in the economy, they can set interest rates at the right level to promote growth without igniting inflation. Investors, it follows, can feel confident about the outlook for interest rates — and the appropriate level of asset prices — if the central bank’s reaction to incoming data is predictable.
Today, however, artists are in the ascendant at the Federal Reserve Bank under the new chair, Janet Yellen. That fact is going to make the art of managing money even more of a challenge going forward.
On one level, the stance of the Yellen Fed is steady as she goes. The policymaking Federal Open Market Committee is almost universally expected to reduce its monthly bond purchases by another $10 billion, to $45 billion, when it meets today and tomorrow, April 29 and 30. That would mimic the decisions made at the three previous meetings, in March, January and December, and put the Fed on track to end its bond purchases late this year and prepare for rate hikes in 2015.
At the same time, however, Yellen has shifted the Fed’s forward policy guidance, which is likely to make it harder for analysts and investors to determine when those first rates hikes will take place and what impact they’ll have on markets. The move to so-called qualitative guidance from the quantitative variety came in March when the FOMC dropped its promise to keep its policy rate at 0 to 0.25 percent as long unemployment remained above 6.5 percent. With the jobless rate already approaching that threshold, at 6.7 percent, the Fed said the outlook for rates would now depend on its assessment of progress “toward its objectives of maximum of employment and 2 percent inflation.”
Don’t expect Yellen to clarify what that means any time soon. Her only public misstep so far came at her first press conference, after the March meeting, when she ignored Fed protocol and actually gave a concrete answer to one question, saying that the Fed’s first rate hike might come about six months after it terminates its bond buying. Markets immediately sensed a more hawkish bias and pushed up Treasury yields, prompting Yellen and her colleagues to row back on the comment and insist that nothing had changed. When Harvard economist Martin Feldstein tried to pin her down at an appearance before the Economic Club of New York on April 16, Yellen responded with appropriately vague Fedspeak, insisting that the central bank wouldn’t take risks on inflation even as it sought to promote growth.
So far, markets have been content to live with the increased ambiguity. The pace of the U.S. recovery flagged enough in the first quarter to convince most analysts and investors that the Fed would keep rates low for a prolonged period but not enough to raise serious doubts about the economy. Other factors, ranging from the crisis in Ukraine to new global liquidity rules for banks, may also be stimulating demand for Treasuries. As Vincent Reinhart, chief U.S. economist at Morgan Stanley and a former Fed staffer, wrote in a weekend note to clients, “The Yellen-led Fed has not yet been tested.”
Such a test may come sooner than many investors believe. Most economists expect the economic expansion to rebound to rate of 3 percent or better in the second quarter, accelerating the pace of job growth. At the same time, the window between now and the second half of 2015, the consensus period when economists expect the Fed to begin raising rates, is slowly but steadily narrowing. According to analysts at Bank of America Merrill Lynch, the market is currently pricing in the first Fed rate increase for September 2015 and 110 basis points of rate hikes in the first year of tightening. On both points, the market consensus is slightly more dovish than the central projections of the Fed itself.
In short, the U.S. bond market is priced for fair weather, not foul. The lack of volatility in recent months suggests as much. Yields on the ten-year U.S. Treasury note have traded in a narrow range of 20 basis points for the past three months; it closed at 2.70 percent on April 28, down from 3 percent at the start of the year. That’s not exactly the kind of price action that indicates concern about higher rates.
The trading range of the ten-year yield has averaged 180 basis points in each calendar year since 1967, and 155 basis points over the past five years, says Joseph LaVorgna, chief U.S. economist at Deutsche Asset & Wealth Management. Given that it’s hard to see rates falling significantly, barring a sudden recession, that historical record implies a lot of upside potential for rates — and potential pain for investors.
“If the market responds, it could be violent,” says LaVorgna. The Fed’s stated policy aims are to generate stronger growth and employment and to boost today’s very low inflation rate back up toward its 2 percent target. Success on those fronts inevitably means higher rates. The Fed can try to jawbone markets to contain any upside move in yields, but qualitative guidance delivers a “much messier message” than its previous communications, contends LaVorgna. “The Fed’s really going to lose control over their ability to talk the market back from the ledge,” he adds.
In May 2013 investors got a taste of what an unexpected hint of a Fed policy change could do to global markets, and it wasn’t pleasant. They had better be prepared the next time a shift in stance looms.
