Front-running the Fed on interest rate hikes

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The biggest takeaway from the latest Federal Reserve Open Market Committee meeting was the reduction in the ‘normal’ rate of unemployment from the 5.2-5.5% range to a 5.0-5.2% range. While the Fed did remove its ‘patient’ language regarding rate hikes, the lower unemployment levels give the Fed more room to stay accommodative. Some thoughts below

“With central banks, the problem with forward guidance is that they can give all the guidance they want but if the conditions on the ground change, the guidance will change. And everyone knows that. The dilemma for getting forward guidance to have an impact on expectations then is convincing markets that the central bank is going to stick to its guidance despite its desire to deviate. If a central bank’s forward guidance loses credibility, markets will discount any guidance from it, front-run their decisions, and the central bank will lose all influence over long-term interest rates.”

That’s what I wrote in November about monetary policy. The markets have been saying from the word go that they did not believe the Fed’s dot plot on where overnight interest rates would be going forward. I didn’t believe it either. And now we are seeing that there is indeed reason to doubt the Fed’s forward guidance.

First, the more hawkish members of the Fed have had to concede that their projections were too aggressive. And so the dot plot of of future interest rates has come down to a level more consistent with reality, and closer to market levels. Market operators will take this as confirmation that time inconsistency in monetary policy decisions makes it important to continue to front run Fed policy decisions as the Fed has consistently been too optimistic about the economic outlook.

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Second, the recent macro data have been terrible, relative to expectations. The question going into the FOMC was how the Fed was going to deal with this fact, while still getting rid of the ‘patient’ language. The Fed acknowledged that recent data have been poor but then maintained that it was still on the same path and that now, it would no longer be patient about the data. And let’s remember, GDP growth is not part of the Fed’s dual mandate. It is employment and inflation that the Fed is charged with watching.

The key, of course, is that the Fed now sees 5.0-5.2% as the normal level of unemployment, shifting the goalposts down 3-tenths of a percent. What this effectively does is make the recent poor data moot. If we get to 5.2% unemployment, there is no guarantee the Fed will hike interest rates, whereas in January there was. Before, the trigger was 5.2% and the threshold was 5.5%, which is where we are right now. Now, the trigger is 5.0% and the threshold is 5.2%. This change also confirms the correctness of front-running the Fed.

Having said all of this, June rate hikes are still on the table. Janet Yellen said so specifically. Let me parse for you what Yellen said about the Fed’s dual mandate and how we should interpret these statements.

Yellen said that low inflation is not an impediment to rate hikes. What she said in the press conference specifically is that the FOMC believes that lower energy prices are “supporting household spending”, and that “as the transitory factors holding back inflation abate” “inflation will move gradually back to our 2% target over the medium-term”. In short, Yellen said the FOMC sees the drop in oil prices as a transitory factor which will have minimal medium-term impact on core inflation and have a positive short-term impact on consumer spending. Therefore, to the degree core inflation remains near the 1.3% level that PCE inflation now reads, the FOMC would feel comfortable raising interest rates.

On the employment side of things, Yellen has consistently said that the lack of wage growth and more comprehensive measures of unemployment like the U-6 level continue to show that some slack still remains in the labor market. What she said yesterday is that while “some cyclical weakness persists”, considerable progress toward full employment has been made and “slack in the labor market continues to diminish”. My sense here is that this is the reason we saw the normal level of unemployment reduced to 5.0 to 5.2% It is in order to accommodate the view from dovish FOMC members that the prior normal level between 5.2 and 5.5% gave the FOMC too little room for maneuver.

In the final analysis, June is still on the table, but much less likely now, given the lowered normal unemployment rate. While the Fed could move the goalposts yet again, I doubt that it will do so because it will reduce credibility too much. Instead, 5.0% unemployment has effectively become a trigger for rate hikes, with 5.2% a threshold for when the Fed could hike. As long as core inflation remains close to present levels, the Fed will raise interest rates if and when unemployment falls into the 5.0-5.2% range.

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