We have expressed concern for some time that markets have been too sanguine about the eventual ‘lift off’ from zero rates, ignoring a recurring Fed narrative that has attempted to guide toward an earlier exit should economic progress (as narrowly defined by the unemployment rate and inflation) justify it. And as it turns out, strong progress toward the unemployment threshold over the past year has prompted the Fed to abandon that target in favor of a wider range of qualitative factors. Nonetheless, when Fed Chairwoman Janet Yellen spoke last week of a lift-off some six months after the end of bond purchases (placing the first rate hike in Q1 2015), fixed income and equity markets freaked out (yet again) at the prospect of an earlier exit than anticipated. Follow-on commentary by various Fed leaders has expressed a bit of surprise at the market’s shock and has reaffirmed that this doesn’t represent a change in forward guidance.
While we would agree that the recent statement is not inconsistent with the Fed’s communication in the past year, we note one very important change of stance in the Fed’s language that seems to have gone unnoticed. In her statement, Chairwoman Yellen observed that the FOMC recognizes that
“policy actions tend to exert pressure on inflation that is manifest only gradually over time.”
While there is nothing particularly remarkable about this phrase because it is an undeniable economic identity (of course it takes a while for monetary policy to trickle through the economy to create inflation!), the mere observation of a patently obvious fact begs the question in our mind, “now why on earth would she say that?!”
Some background is necessary to fully appreciate why this matters. Forward guidance thresholds of inflation and unemployment were put in place to better communicate the Fed’s reaction function (the way in which the Committee adjusts policy in response to changing economic condition). As Yellen herself has described the thresholds, they would act as ‘automatic stabilizers’ in the face of shifts in the economic outlook. Importantly, because they communicate how the Fed will respond to incoming data, they demonstrate a very reactive stance by the Fed. As we’ve said before, this has been an effective way to reshape the yield curve in anticipation of eventual lift-off from a zero fed funds rate.
However, the Fed just abandoned threshold guidance in favor of more ‘normal’ qualitative guidance based on a wider range of factors that better reflect conditions “as they are likely to evolve over coming quarters.” When combined with Yellen’s observation that the Fed’s actions manifest only gradually over time, it is hard not to see a change in forward guidance that is far more proactive than it has been in the past. The Fed seems to be communicating that, on balance, it is more concerned with the as of yet unobservable effect of its stimulus efforts than it is about the benefits of continued easing. In our minds, this may be reflective of the classic watershed moment in central bank policy making when decision makers begin to worry that they’re behind the curve in raising rates. The hawkish transition at the Fed that we discussed in our last communication may be well underway.