Fed Priority of Rates Integrity Prompts Outlook Struggle
Federal Reserve officials are grappling with how they might eventually exit from their plan to keep interest rates low through late 2014 without jolting markets.
Policy makers have relied on communications about their rate expectations to provide additional stimulus after cutting their benchmark rate to near zero in December 2008. Now, they’re seeking to link their commitment more closely to changes in the economic outlook. Giving investors more information about the threshold for a shift would make it easier to change policy, said Ethan Harris, co-head of global economics research at Bank of America Merrill Lynch.
“When you present scenarios, you’re showing the public that you will react; or in other words, if inflation becomes a problem, you will hike rates earlier,” Harris said. “If you guide the markets in advance and explain to them the reaction function, then they’ll kind of do your job for you,” so policy makers won’t “have to actually hike to convince the markets that they’re hiking.”
There’s little indication the Federal Open Market Committee is ready to alter its 2014 plan, with the jobless rate at 8.2 percent, well above its 5 percent to 6 percent estimate for full employment. Two top policy makers, William C. Dudley, president of the Federal Reserve Bank of New York, and Fed Vice Chairman Janet Yellen, both endorsed the commitment last week.
The FOMC’s decision to connect the plan more clearly to its outlook might gain urgency if the economy continues to expand following gains in the labor market, sales and manufacturing.
Rising Retail Sales
Retail sales added to signs that growth is strengthening, with last month’s 0.8 percent gain almost three times as large as projected, according to Commerce Department data released yesterday. The increase shows consumers are weathering a 19 percent rise in gasoline since Dec. 31. The average price for a gallon of regular unleaded was $3.91 on April 15, down from $3.94 on April 5, according to AAA, the nation’s largest motoring group.
“We are going to have to deal with it one way or another,” Charles Plosser, president of the Federal Reserve Bank of Philadelphia, told reporters last week, referring to the 2014 forecast. “I would like to get us to move away from that and substitute something that is a little more systematic and coherent about how it depends on the economy.”
Plosser is a member of the Fed’s communications subcommittee, which is having “ongoing discussions,” he said, without indicating that any changes are imminent. The Fed meets April 24-25.
“The FOMC so far has become more transparent about its objectives, more transparent about its policy plans, but there is one more objective it hasn’t met and that is to become more transparent about its policy strategy,” said Laurence Meyer, senior managing director at Macroeconomic Advisers LLC in Washington and a former Fed governor.
To do this, the FOMC might release different interest-rate paths that correspond to changes in inflation or employment, although members aren’t likely to reach an agreement next week, Meyer said.
The minutes of the March FOMC meeting show they’ve already begun talking about ways to include more quantitative or qualitative information in the statement to provide a tighter link between their outlook and monetary policy.
Fed officials started tying their low borrowing-cost expectations to the calendar in August, when they replaced their statement that the rate for overnight loans among banks would stay very low for an “extended period” with a date of at least mid-2013. They pushed that date back to at least late 2014 in January.
Signs of Strength
With the economy showing signs of strength and central bankers giving no sign another round of bond purchases is imminent, communication probably will be the main policy tool, according to Mark Spindel, chief investment officer at Potomac River Capital, a Washington hedge fund that manages $250 million. The Fed bought $2.3 trillion in Treasury, federal- agency and mortgage-backed securities in two asset-purchase programs that ended in June.
“They are done with quantitative easing,” barring significant further weakness in the economy, Spindel said. “All of the effort is going to be on guidance: What date, how do they describe it, do they want to conditionalize it, do they want to lengthen it or shorten it?”
Europe’s Debt Crisis
Some of the world’s biggest bond investors, including Pacific Investment Management Co.’s Bill Gross, still predict the Fed will use its balance sheet for more stimulus as growth weakens and Europe’s sovereign debt-crisis returns. Speculation the Fed will buy home-loan bonds has led 2012 returns on government-backed mortgage debt to top Treasuries by 0.95 percentage point, Barclays Plc index data show.
Money-market-derivatives traders predict the Fed will lift its target a few months before the late 2014 forecast. Forward markets for overnight index swaps, whose rates show what traders expect the federal-funds effective rate will average over the life of the contract, signal a quarter-percentage point advance around July 2014, according to data compiled by Bloomberg as of April 13.
Yellen outlined on April 11 scenarios that might warrant a policy shift. For example, if the recovery is “unexpectedly strong” and unemployment is on track to fall to 6 percent at the end of 2014 with inflation creeping above 2 percent, that would call for the Fed to raise rates sooner than the current commitment.
Appropriate to Modify
“The guidance does not state that the committee will keep the funds rate exceptionally low until at least late 2014,” she said in a speech. “I’d consider it completely appropriate to modify the specification of the forward guidance in response to significant changes in the economic outlook.”
A weaker outcome would merit low rates for longer than 2014 and further easing steps “could be warranted,” she added.
Since becoming chairman in 2006, Ben S. Bernanke has pushed for the central bank to increase its openness and increase public understanding of the Fed, including by holding regular press conferences. In January, the Fed adopted an explicit inflation target of 2 percent and released, for the first time, policy makers’ projections for the appropriate path of interest rates. They will update those projections after their meeting next week.
“This is the whole Bernanke transparency approach: ‘Let’s be as public as possible about what assumptions we’re making so that people understand that what we’re doing is logical and consistent,’” said Harris, author of “Ben Bernanke’s Fed: The Federal Reserve After Greenspan.” “You tell the markets the way you act and then the markets move in front of you because you’ve explained it.”
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