In the ultra-low interest rate environment, the Federal Open Market Committee has had to provide explicit forward guidance to assure markets of its commitment to maintaining accommodative monetary policy well into the future. This firm forward guidance was often calendar-based or temporal.
With the economic recovery well under way, there are crosscurrents on the macro landscape. Employment is blowing hot, but inflation is blowing cold. Whereas it is clear that a turning point in monetary policy is approaching, the timing of an initial rate increase remains elusive. Given the dynamic economic situation, the FOMC has to soften its current forward guidance and needs greater latitude.
What will happen at the March FOMC meeting? The FOMC will drop “patient” from its statement and replace it with a softer commitment. By eliminating calendar-based forward guidance and reverting to a more subjective, data-dependent posture, the FOMC is essentially normalizing its guidance. The committee sent up trial balloons for such a change in the minutes of the January meeting as well as in Fed chair Janet Yellen’s testimony before members of Congress last month. A market shrug in response to any change in policy wording, as has happened before, would provide the FOMC the comfort it needs to eliminate temporal guidance.
What do investors need to know about this? First, squishier FOMC guidance will contribute to growing market volatility. With the reversion to a data-dependent posture by the FOMC, every new release of macro data can sway the market’s view of Fed policy. Expect more-frequent market gyrations, especially around the release of key data such as inflation, employment and wage growth. Investors should expect even seemingly routine surprises in incoming data to have a bigger impact on asset prices and interest rates.
Second, there will be no rate liftoff until weak and falling inflation reverses course. The Fed’s dual mandate for monetary policy keeps the focus of the FOMC squarely on full employment and price stability. That means there are two conditions that need to be met before a rate increase can occur. For most FOMC members, the full employment requirement is either very close to being checked off or was checked off some time ago.
Price stability is the part of the mandate that keeps FOMC members up at night. With inflation below the FOMC’s target range for 33 straight months — and expected to drift further away over the next few months — the FOMC is not likely to check off the inflation box any time soon.
Is a Fed rate hike on the table for June? Yes, it is on the table — but it is very unlikely. With the FOMC adopting a more data-dependent posture to policymaking, the possibility of incoming data swaying enough members to take action exists at every meeting beginning with June. With inflation at its present anemic level, however, it simply is not plausible that there would be sufficient support to begin normalizing rates in June.
So when will the FOMC raise interest rates? My view is that there will be no interest rate increase until December 2015. This view is based on two factors:
First, I expect inflation will continue to decline or remain at disinflationary levels through sometime in the fall. FOMC members will likely want to see a sustained upward trend in inflation before voting in favor of a rate hike. Hence, the committee will not likely find sufficient support to move forward until December.
Second, the perceived cost of raising rates too early is very high. FOMC members are acutely aware of the asymmetry of risk around the timing of rate hikes. “I believe that the risks of lifting the federal funds rate off of the zero lower bound a bit early are higher than the risks of lifting off a bit late,” New York Fed president William Dudley said in a speech two weeks ago. “This argues for a more inertial approach to policy.”
Shehriyar Antia is the founder and lead strategist at Macro Insight Group, an investment strategy firm based in New York. Previously, he worked on quantitative easing programs and monetary policy as a senior market analyst at the Federal Reserve Bank of New York.
Get more on macro .
