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Is a Fed rate hike coming sooner than markets expect?

February 25, 2015
   
   

As is often the case when central bankers speak, those on the receiving end parse every word, and interpretations vary. The Federal Reserve chair, Janet Yellen, gave analysts and market participants much to ponder in her recent testimony before committees of Congress. Although her remarks were balanced and offered insight on the FOMC’s view of current and future economic conditions, she did not provide a clear timeline for the course of monetary policy. Or did she?

The Fed chief stated: “The FOMC’s assessment that it can be patient in beginning to normalize policy means that the Committee considers it unlikely that economic conditions will warrant an increase in the target range for the federal funds rate for at least the next couple of FOMC meetings.”

This clear statement—clear in central bank terms—along with the continued use of the soothing buzzword “patient,” was almost immediately followed by her comment that the committee will change its forward guidance if conditions continue to improve as anticipated. In true central bank-speak, Yellen went on to say, “However, it is important to emphasize that a modification of the forward guidance should not be read as indicating that the Committee will necessarily increase the target range in a couple of meetings. Instead the modification should be understood as reflecting the Committee’s judgment that conditions have improved to the point where it will soon be the case that a change in the target range could be warranted at any meeting.”

In my view, this implies that the Federal Open Market Committee, or FOMC, will raise the federal funds rate as early as mid-June. However, given that a number of the committee’s  voting members have publicly voiced concerns about the strength of the economy, and allowing for a possible hiccup in future economic data, the first rate hike could occur later, as most market participants expect. Those who believe the FOMC will wait until year-end argue that the labor market is still some distance from reaching full employment. In addition, many want to see market-based measures of inflation expectations rise before changing their extended timeline for a rate increase.

While there is merit in this position, a number of factors suggest that a rate hike should come sooner. These include:

  • Strong performance of the service sector
  • Growing concern about the costs of maintaining policy interest rates at the zero bound
  • More relaxed lending conditions resulting in increased borrowing and signs of a reversal in the decline of money velocity

Once the FOMC draws closer to raising policy rates, it should consider doing away with its reliance on forward guidance. This tool, while useful when the committee was dependent on nontraditional monetary measures, has led market participants to invest substantial time and effort trying to interpret FOMC statements rather than make their own judgments about the economy and financial markets. The notion that the FOMC can articulate its “data-driven” judgment in such a way as to avoid becoming bogged down in the minutiae of dealing with the market’s fixation on buzzwords such as “patient” and “extended period” seems problematic in light of the history of reaction to forward guidance. FOMC members themselves have said that forward guidance may hinder rate normalization if market participants were to remain overly sensitized to “Fedspeak.”

The next chapter in the normalization of U.S. monetary policy will no doubt be an interesting one.