The first week of March’s economic data releases essentially represent the final nails in the coffin for the Federal Open Market Committee’s use of the word “patient” to describe its approach to beginning the process of policy normalization.
As I noted following publication of the January FOMC meeting minutes, the Committee would like to regain flexibility to raise rates once their confidence in the inflation outlook firms, and Chair Yellen, in her Congressional testimony last week, reiterated this message. The data published on 2 March 2014 revealed that January core PCE inflation was unchanged from the prior month at 1.3 percent y.o.y. on a rounded basis. This should provide policy makers with comfort that inflation may be stabilizing after declining in recent months. They will also have noted the upturn in market-based measures of inflation compensation. And the employment report published on March 6 evidenced continuing strength in payrolls growth, which should eventually lead to a firming of wages once the labor market hits full employment conditions.
The Committee has also accomplished an important communications objectives in recent weeks, namely, convincing investors that removing the word “patient” from the policy statement does not make an initial rate increase imminent, and that the Committee will continue to take a data-dependent approach. They will have been heartened by the market response to this message following the January minutes and Chair Yellen’s testimony. These communications led to a firming of expectations for “patient” to be removed from the March policy statement, yet there has not been an outsized increase in fixed income implied or realized volatility. Importantly, expectations for a June rate increase as measured by interest rate futures contracts have not risen very much in recent weeks. This is consistent with investors understanding that removing near-term forward guidance from the March statement does not make a rate increase in June a “done deal”.
With the Committee now set to remove the “patient” language from the March policy statement, it is tempting to conclude that we are moving into a period of full data-dependency, and that market volatility will increase sharply and remain elevated for an extended period. However, there are a number of reasons to doubt this interpretation. First, the Committee has shown a preference for making only marginal changes to its messaging in order to ensure that eventual policy tightening, after years of near-zero short-term rates, does not lead to an unwarranted tightening of financial conditions. So it is possible that the Committee may introduce new statement language aimed at assuring investors that at least initially, the pace of rate increases will be gradual. In recent speeches, a number of policy makers have stressed this message, and have downplayed the importance of the timing of the first rate increase. But more importantly, even if the Committee does not provide such assurances, there remains a potent form of long-term forward guidance in Committee communications, namely, the statement language that, “… 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.” This sentence serves as a powerful anchor that reduces uncertainty about the pace of rate increases and the level of policy rates over the next few years. And the message is reinforced by the Committee’s quarterly Summary of Economic Projections (SEP). The most recent SEP, from December of last year, suggests that core policy makers view an end-2015 IOER rate of 1 percent as appropriate, with the rate increasing to 2.5 percent by the end of 20161. This would leave policy rates well below what Committee members view as the long-run equilibrium level, even as the Committee projects that it will be close to achieving its inflation and employment objectives by that point. The Committee will publish updated projections at the March meeting, but recent history shows that the projected rate path over a two-year horizon changes only very gradually. For example, over the course of four SEPs last year, the end-2016 policy rate as measured by the median Committee participant’s projection moved higher by just 25 basis points.
Changes to forward guidance are coming in the March statement, as the Committee seeks to regain the optionality to begin raising rates potentially as early as June. But so long as the Committee retains the soft commitment to keep the policy rate below the long-run equilibrium level, the process of lift-off should be relatively smooth. Whether and when to remove this long-term forward guidance will be the next communications challenge the Committee will face, but one they will likely put off until they are confident that the process of rate normalization is proceeding smoothly.
1The low end of the inter-quartile range of Committee participants’ rate projections is used as a proxy for the views of core Committee members.