Full analysis: The Fed will not raise rates until at least mid-2015

The Federal Reserve’s Open Market Committee met yesterday. As expected, the Fed Funds rate stayed at the zero bound. Most Fed watchers, however, wanted more clarity on the Fed’s quantitative easing timetable, which the Fed laid out as transparently as possible. But the Dow initially fell 170 points on the news and 10-year bond yields initially rose to 2.28%. Here are my thoughts on the Fed’s actions.

The Fed has a formal dual objective of maintaining price stability and full employment. But we also know that the Fed has long kept an eye on asset prices, looking to keep them from falling. This used to be known as the Greenspan Put and has now become the Bernanke Put. With the Fed now taking extraordinary measures toward monetary accommodation, we are now also seeing that the Fed also has to consider political fallout too. I believe all four of these factors are affecting the Fed’s policy path and will explain what’s behind the Fed’s ideas on tapering and interest rates.

Here’s what the Fed said yesterday through the Federal Reserve Open Market Committee’s policy statement and Ben Bernanke’s subsequent press conference:

• The Fed believes downside risks to the economy in terms of low economic growth, disinflation, or deflation have diminished since the last FOMC meeting.
• The Fed now believes the economy is gaining strength and expects the economy to expand at a moderate but improving pace above 2% in 2013 and 2014.
• The Fed also believes that, while inflation has slipped well below its 2% target level, the medium-term inflation trend is stable. Most FOMC members expect inflation will rise toward that target over the medium-term as the economy improves.
• The central tendency of FOMC unemployment forecasts were as follows:  Year-End 2013: 7.23%, 2014: 6.60%, 2015: 6.02%, Long-run: 5.57%. This is slightly lower than the previous forecast by -0.12%, -0.17%, -0.19%, and  0.00% respectively.
• Given this upbeat outlook for the economy, inflation and employment, the Fed feels comfortable withdrawing policy stimulus at a moderate pace.
• First, the Fed will become less accommodative by tapering its asset purchases at some point this year, if the forecasts hold. The Fed would end QE by the end of 2014.
• Second, the Fed would begin to think about hiking rates only when the unemployment rate hits its threshold of 6.5%, projected to occur sometime in 2015, implying the Fed will not raise rates until at least mid-2015, if forecasts hold.
• All of this, particularly the Fed’s asset purchases, is dependent on the path of the economy. Ben Bernanke was at pains to stress this fact at the press conference, adding that the pace of asset purchases could even rise. He said “the Most important thing I want to convey… [is that] our policies are economic dependent.” The language the Fed statement uses was that the “Fed is prepared to increase or reduce the pace of its purchases …as outlook for labor market or inflation changes”
• The vote was 7-2. There were two dissents: Elizabeth George wants less accommodation and James Bullard wants more.

None of this is new information. Fed officials have been saying all of this for weeks. Yesterday, the Fed simply reiterated their starting position, adding transparency and clarity. Bernanke told reporters specifically that the Fed’s unemployment target was below 6%, with 7% a guidepost for paring asset purchases and 6.5% as the threshold for considering raising rates. Based on Fed projections that works out to be paring asset purchases by the end of the year, with rate hikes only happening by mid-2015.

Now, the problem here is in terms of market expectations. As you know by now, non-interest rate monetary policy like quantitative easing works mostly through an expectations and private portfolio balance channel. This means that QE is mostly about telegraphing the Fed’s stance as either more or less accommodative, allowing investors to shift private portfolio preferences as a reaction. What the market heard yesterday was that the Fed is relatively bullish on the US economy. So the Fed will move to a less accommodative stance over time, with a decline in asset purchases preceding gradually through 2014.  Tightening via rate hikes won’t occur until at least 2015.

The market sold off on this news, in what I believe was an overreaction to the Fed policy statement because the market is pricing in a hike of 50-75 bps by mid-2015 when Bernanke said the Fed would first hike rates. According to CME data, the market is putting a 52% probability on a rate hike by December 2014. Clearly, the Fed’s communication strategy is not working because the tapering talk has spooked the market into thinking there is more tightening than there really will be. Witness the remarks from Paul Krugman as indicative of the alarm some have regarding Fed’s timetable for less accommodation.

Here’s what I think is influencing policy:

• First, the Fed wants the economy to grow and employment to rise. That’s one side of its dual mandate. And Bernanke has been ultra-transparent at telling us what the guidepost, threshold, and target are here. You can’t get any clearer. Bernanke also led his remarks yesterday by saying that tighter fiscal policy is reducing growth. This implies that the Fed’s accommodative stance is compensating for tighter fiscal policy because Bernanke laid out a specific unemployment rate guidepost, threshold, and target guiding Fed policy. In the absence of tightening fiscal policy, these levels would be hit earlier and the Fed would therefore remove accommodation and tighten earlier.
• Second, on inflation, the second side of the Fed’s dual mandate, the Fed seems to have two thresholds for inflation, not just one. Based on Bernanke’s commentary yesterday and in the past, it is clear he views low inflation as being as much an economic threat as high inflation. My read here is that the Fed will move to keep inflation around 2% over the medium-term but will work to keep it from falling below 1% in the short-term. On some level, that makes the Fed’s lack of concern about falling inflation and inflation expectations puzzling. But it’s not as puzzling when you consider pieces of the puzzle not associated with the Fed’s formal dual mandate.
• Third, the Fed has long targeted asset prices. Usually, the Fed is concerned about keeping asset prices from falling. And this is exactly the Fed has moved to buying mortgage-backed securities. The Fed believes that it can underpin house prices by doing so. However, in the wake of two massive back-to-back asset bubbles in the US in equities and then in housing, the Fed is now also concerned about preventing its policy from being blamed for asset bubbles. Indeed, we see many signs that investors are reaching for yield in emerging markets, high yield, and leveraged loans as the yields in government and investment grade bonds decline. And investors have shifted into riskier assets all around. My view here is that the Fed’s zero rates and QE have introduced a distortion into markets that favour riskier, higher yielding investment classes. These areas are receiving  relatively more capital than they should, pushing yields down in those asset classes and risking a misallocation of resources if these investments are found to be unproductive when the economic cycle turns down. The Fed is onto this but feels it must act anyway. But I believe the risk of asset bubbles is having an impact in causing the Fed to be less accommodative.
• Fourth, political pressure is always a concern. There are many voices within the Fed and outside that see the Fed’s policies as reckless. Former Fed Chair Paul Volcker went as far as to say that he thinks a dual mandate is nonsense. We have seen this before, with former Fed official Bill Poole saying that the Fed risked negative equity by purchasing all the dodgy assets it bought during the panic phase of the crisis. As with the talk about bubbles, this can only serve to dampen the Fed’s enthusiasm for accommodation.

Putting all of this together with the Fed’s policy statements leads me to believe that the Fed is more dovish than the market believes it is. I would call the Fed’s statement neutral to dovish whereas people like Krugman think the Fed is being more hawkish. I was on BNN yesterday before the Fed news and I predicted the Fed would simply reiterate its talking points based on everything I outlined here. And that’s what they have done. But I also said that it was an open secret in Washington that Ben Bernanke will step down as Fed chairman and Janet Yellen, a dove is the likely successor. Anyone that President Obama picks is likely to be fairly dovish and so Bernanke doesn’t want to be turning hawkish just as he leaves. As I wrote Fed watcher Tim Duy, If Bernanke hands off to someone as dovish as Yellen, he can’t possibly tighten at this juncture. Expecting this is unrealistic. In fact, what Bernanke is now saying about FOMC policy is almost exactly what I could imagine Janet Yellen saying as Fed Chair.

So, as Felix Salmon wrote, “The message I’m getting from FOMC/Bernanke is dovish; the markets are hearing it as hawkish.” Why? I think because people are fixated on QE tapering. No wonder the Fed hates the word tapering. Bernanke was forced to lay out an expected timeline for tapering asset purchases while trying to walk back the taper talk which is pushing up mortgage rates. And that has the market unhinged. But Ben Bernanke’s discussion about Abenomics gave clues to why he is unfazed by this.

Bernanke was asked by a Japanese reporter whether he still supports Japan’s economic policy in the face of the extreme levels of market volatility in Japan. Bernanke said “I’m supportive of what Japan is doing,” arguing that aggressive policy is warranted even if it causes the markets to be volatile initially. I thought this was interesting. First, Bernanke’s support of Abenomics implicitly shows him as relatively dovish. He implied he would want the same policies in the US if deflation threatened the US economy. And if Bernanke thinks Abenomics will initially mean volatility that diminishes over time as the markets get used to the new policy, he is implying that the Fed’s telegraphing its tapering timetable is similar; markets will learn over time that the Fed will stick to a timetable based on the guideposts, thresholds and targets it has laid out. Bernanke’s comments on Japan suggest that he believes the short-term volatility in markets due to aggressive monetary policy is worth the benefits of its long-term objectives and that he will continue to telegraph the Fed’s expected tapering timetable with respect to the FOMC’s economic forecast central tendency.

In sum, the Fed is relatively dovish and it will remain so for the foreseeable future.