The Fed’s final act in this extraordinary cycle

October 31, 2014 07:00 PM

Higher interest rates are coming. The $64,000 question, as with all things market related, is timing. 

Fed officials, and not just hawks, are weary of being stuck at the zero lower bound. They would like to get on with “normalization” at the earliest reasonable date. 

But that antsiness to move the federal funds rate from zero after nearly six years is tempered by caution. Policymakers want to move soon, but not too soon. They don’t want to move too late, but late enough to extract as much labor market progress as possible. 

With inflation well below the 2% target and with no widespread signs of financial imbalances or instability, there is a sense the Fed still has leeway to remain accommodative for a “considerable time,” as the Federal Open Market Committee (FOMC) repeated Sept. 17. That phrase was tied to the end of large-scale asset purchases, which is expected to come at the Oct. 29 meeting, but that doesn’t necessarily mean the FOMC will dump “considerable time” completely when QE3 is over. 

Some vestige of that “forward guidance” could be retained, along with the conditional pledge to keep the funds rate “below normal” for “some time” after the FOMC reaches “mandate-consistent levels.”

The mainstream view is that the FOMC needs to start the “normalization” process as soon as convincing economic data permit.The FOMC has never disavowed the market’s mid-2015 expectation for the first rate hike, so that remains the presumption for now. But the timing is subject to change, as Fed Chair Janet Yellen warned again at her third post-FOMC press conference. 

“If the economy proves to be stronger than anticipated by the committee, resulting in a more rapid convergence of employment and inflation to the FOMC’S objectives, then increases in the federal funds rate are likely to occur sooner and to be more rapid than currently envisaged,” she said. “Conversely, if economic performance disappoints, increases in the federal funds rate are likely to take place later and to be more gradual,” she added.

That is not as symmetrical a statement as it might seem, because the FOMC’s predisposition, as expressed in its revised Summary of Economic Projections (SEP) is that the economy will continue to grow well above trend, further reducing labor market slack and pushing up inflation. So the odds of delay would seem less than those of moving earlier, or at least of moving in line with market expectations.

The latest SEP forecasts are not quite as optimistic as those announced in June, but the 17 FOMC participants still see growth of 2.6% to 3.0% next year and 2.6% to 2.9% in 2016 — well above their “longer run” or potential growth estimate of 2.0% to 2.3%. 

What’s more, the unemployment projection was lowered to 5.4% from 5.6% by the end of next year; to 5.1% from 5.4% in 2016, and to 4.9% from 5.3% in 2017 — compared to a longer run 5.2% to 5.5%. And they raised their PCE inflation forecasts moderately, with inflation reaching 1.7% to 2.0% by the end of 2016 and 1.9% to 2.0% by the end of 2017. 

Meanwhile, the median assessment of the “appropriate” funds rate for the end of 2015 was increased from 1.13% to 1.375%. For 2016, the went from 2.50% to 2.875%. The median funds rate for the end of 2017 is 3.75%%—same as the median estimate of the “longer run” or equilibrium funds rate. 

Might the FOMC raise rates earlier than mid-2015? It’s certainly possible, dependent on economic data. Whenever “lift-off” comes, the process of engineering higher short-term rates in the face of a huge Fed balance sheet will be very interesting. 

Yellen and others have often expressed confidence the “tools” they have been testing will suffice to raise the funds rate and other money market rates, despite $2.9 trillion in reserves exerting downward pressure on them. But those tools have never really been tried on a vast scale. 

In its new “policy normalization plans and principles,” the FOMC figures on first raising the interest rate on excess reserves from the current 25 basis points and the rate on overnight, fixed rate reverse repurchase agreements from 5 basis points. 

The plan is for the funds rate to fluctuate within a corridor—with the interest on excess reserves (IOER) providing a ceiling and the overnight reverse repo (RRP) rate setting a floor.

The FOMC does not currently plan to actively shrink reserves through sales of mortgage backed securities or Treasury bonds. It will only shrink them passively and gradually by discontinuing reinvestment of principle payments sometime after the first rate hike. Even then, reinvestment may be tapered rather than halted. 

But officials recognize their tools may not work as efficiently as hoped. Hence the FOMC’s concession that it is “prepared to adjust the details of its approach to policy normalization in light of economic and financial developments.” 

As the FOMC attempts to normalize, its strategy is to firm monetary policy gradually, using largely untried tools, but is fully aware that some course corrections may be required. Ultimately, everything, including asset sales, has to be on the table. 

About the Author

Steve Beckner is senior correspondent for Market News International. He is heard regularly on National Public Radio and is the author of "Back From The Brink: The Greenspan Years" (Wiley).