The move from QE to forward guidance has always been about normalizing policy
So finally we get to see what the Yellen Fed is all about. And it is not as dovish as people thought it would be.While the noises Yellen made concerning the jobs market came across as dovish, behind the scenes a more hawkish tone has developed at the Fed. The fact is the move from QE to forward guidance has always been about normalizing policy – and that is tightening. The Fed has been telling us this for a year now. But only now are people understanding it means hikes are coming sooner than later.
Before I go into my analysis of the FOMC statement and future Fed policy, I want to talk about the abandonment of the Evans rule and the rules-based approach to Fed policy. The Fed is in an unprecedented scenario. With rates at zero percent, it has had to turn to unconventional monetary policy for its main policy tools. As such, the Fed is literally making policy up as it goes along. There can be no pretenses here that the Fed actually knows what it’s doing because it doesn’t. We have never faced this situation before. So, the use of large scale asset purchases and forward guidance as policy tools, while laid out in theoretical terms long ago, are only now being employed as policy tools for the first times. That means we are going to see a lot of twists and turns as the Fed fine tunes its approach.
In October, I predicted that the Yellen Fed would be predicated on a rules-based approach to forward guidance. But this prediction has not panned out at all. It is now officially just the opposite. The Evans rule of basing forward guidance on the unemployment rate is dead because we have already effectively reached the 6.5% unemployment threshold. Rather than implement a battery of guidelines to bolster the Evans rule like the inflation floor that St Louis Fed President Bullard advocated, the Fed has moved away from the rules-based framework entirely. As Marc Chandler puts it, the Yellen Fed marks the return of ad-hockery. And I think this will mean volatility.
Again, the Fed is making things up as it goes along. And for the Fed to switch to an ad-hoc framework with no specific guidelines is to make Fed policy more opaque just as it starts policy normalization. I think this bears noting because we are getting a double whammy here: a removal of rules-based transparency to forward guidance and a normalization at the same time. To me, this means market volatility. But it also means policy normalization. I’ll explain below.
Now, on what the Fed said specifically, Janet Yellen, in her press conference told us we should pay more attention to the FOMC statement than the accompanying Fed forecasts, both of which are in today’s links. I think this is curious because, yet again, it leads to fewer specific guidelines and more ad-hockery. If one looks at Fed forecasts, what we see though is this:
- Rate hikes by the end of 2015 for 14 of 16 forecasting FOMC members
- Aggregate expectation of rates at 1% by the end of 2015 and 2.25% by the end of 2016
- An aggregate expectation of between 5.5 and 5.9% unemployment by the end of 2015
- One dissent from Naranya Kocherlakota of the Minneapolis Fed
What this implies in aggregate then is that the Fed has already moved to a tightening bias with the elimination of the Evans rule and that this bias is reflected in the taper of large scale asset purchases. Further, with the Fed in tightening mode, actual rate hikes are now on the table, with a hike expected in early to mid 2015 when the unemployment rate is expected to be around 6%. Effectively, 6% unemployment should be considered the Fed’s trigger for rate hikes. Yellen is pointing to the FOMC statement and not saying this explicitly now because she wants the Fed to have more wiggle room now that the Fed is tightening. In fact, I see the removal of the rules-based approach as part and parcel of normalization because it shows the Fed moving to a ‘normal’ policy approach in which it gives a broad interpretation of the macro environment as guidance for hiking or lowering rates. The Yellen Fed wants you to ignore all the specifics and forecasts and focus on the FOMC statement, just as you would have done before the zero rate policy came into being. That’s because it wants to normalize Fed monetary policy.
Where is this coming from? Well, as I wrote in November, “at some point during the QE3 experiment, the cries that the risk that Yellen had outlined regarding spillover effects started to become ever louder. Yellen had already said that, “it is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage” back in 2010. Her speech on unconventional monetary policy in 2011 was merely a confirmation of this view that bubbles were a risk. But it was not until Jeremy Stein came out in February 2013 with a speech about the perils of “reaching for yield” that the anti-QE view took full form.” And it was three months later when Bernanke started to muse about tapering QE.
The Fed is also afraid of not having any ammunition left for when the next recession hits. Having rates at zero percent when we have another recession means the Fed has no choice but to rely exclusively on unconventional monetary policy in the next recession. And that makes a Japanese outcome much more likely because, despite what the Fed says, it knows that unconventional policy has less impact than conventional interest rate policy using the fed funds rate.
And finally, the Fed’s composition is more hawkish now. If Yellen wants to be able to get through her first few sessions as chair without too many dissents – and I believe she does in order to build the credibility that fewer dissents does – then she needs Plosser and Fisher onboard. And they were onboard this go ‘round. Having Plosser and Fisher onboard means being more hawkish and it means the timetable for hikes is accelerated. But, Yellen is not as hawkish as Fisher and Plosser. Her FOMC presser yesterday demonstrated this. So, pointing to the FOMC statement instead of the Fed forecasts also gives Yellen the wiggle room she needs if the economy turns down and the timetable needs to back up.
Bottom line: The Fed is in tightening mode. QE is done at the end of this year And hikes are coming in early to mid-2015. The economy would have to deteriorate significantly to get the Fed away from its taper of QE. But the hiking timetable has less of a burden to overcome and could be postponed if the economy stalls. I think this is bearish for bonds and for equities as well, especially in view of the run up in shares in the last year.