Fed Watch: Unintentionally Hawkish

The outcome of the FOMC meeting was pretty much as I anticipated.  Asset purchases were cut by $10 billion.  The Evans rule was dumped.  And forward guidance was enhanced to emphasize that rates would be low for a long, long time.  All seems pretty much in-line with the general consensus.

Yet financial market participants took a hawkish view of the news.  Bonds were trounced – the 5 year Treasury yield lept almost 15bp.  Market participants clearly saw something they didn’t like.  This despite what was a reasonably dovish inaugural press conference by Federal Reserve Chair Janet Yellen.  Indeed, she strongly emphasized the new forward guidance language:

When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.

This makes clear that low rates may persist after the unemployment rate hovers closer to 5.5%.  In other words, in the absence of clearly higher inflation or a reasonable forecast of higher inflation, the Fed is in no rush to push rates to a more normalish 4%.

Low rates, however, are not the same as near zero interest rates.  And the interest rate forecasts seems to imply tighter policy in 2015 and 2016 than implied by the December projections.  But during the press conference, Yellen denied the little dots contained any meaningful forecast information.  Again, she pointed to the statement as the relevant guidance.  And the statement clearly says to expect a period of low interest rates and takes no firm position on the exact timing of the first rate hike.  Sounds pretty dovish.

Moreover, it is not clear that the patterns of the dots represent a meaningful change in policy even if taken at face value.  Consider the dots in the context of this line from the statement:

The change in the Committee’s guidance does not indicate any change in the Committee’s policy intentions as set forth in its recent statements.

The dots always made clear that rates would remain low even as unemployment fell.  Arguably, the Fed did nothing more in the statement than turn unofficial policy into official policy.  And the slight move forward in the rate forecast was completely reasonable given the optimistic forecast of the unemployment rate.  Assuming the Fed is following some Taylor-type rule, a lower unemployment rate would be sufficient to nudge forward the timing of the first rate hike.  That seems perfectly consistent with the Fed’s reaction function as detailed in recent statements.

All in all, it seems relatively easy to make a case that this was a dovish policy decision and a dovish press conference.  Others will make the case, and offer more details, I expect, about things such as Yellen’s emphasize on a wide array of labor market indicators as evidence of slack.  What about a hawkish version?

If I am making a hawkish interpretation, it starts with the end of the Evans rule.  Everyone seems focused on the unemployment part of the Evans rule, while my attention is on the inflation part.  The Evans rule allowed for the Fed to reach their inflation target from above.  It provided wiggle room on the target as long as unemployment was above 6.5%.  With the end of the Evans rule, the Fed sends a signal that they no longer find it acceptable to reach the target from above.  They intend to reach it from below.  2% is officially once again a ceiling.  Indeed this is pretty much made explicit in the statement:

The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.

Low rates are only guaranteed if inflation remains below 2%.  Above 2%, you had better expect a fast and furious reaction.  Moreover, Minneapolis Federal Reserve President Narayana Kocherlakota’s dissent makes clear the topic on the table is a below-target approach for inflation:

Voting against the action was Narayana Kocherlakota, who supported the sixth paragraph, but believed the fifth paragraph weakens the credibility of the Committee’s commitment to return inflation to the 2 percent target from below and fosters policy uncertainty that hinders economic activity.

Responding to a question about the dissent, Yellen did emphasize that she did not want to undershoot inflation, but she made no mention of a willingness to overshoot inflation.  Ceiling.

Moreover, the new-found 2% ceiling puts a cloud over the importance of Yellen’s optimal control theory.  The whole point of that exercise was that the cost of allowing inflation to rise above 2% was less than the cost of high unemployment.  Seems like this idea is abandoned when you explicitly rule out the ability to reach the target from above.

The whole tenor of the policy discussion has a hawkish tone as well.  As the Washington Post’s Ylan Mui notes, the policy focus has shifted entirely to the timing of the first rate hike:

The nation’s central bank said Wednesday it will look at a broad swath of indicators – including job market data, inflation expectations and financial developments – as it determines when to raise rates for the first time since the recession hit. The deliberately vague wording is a retreat from the Fed’s concrete promise to leave rates untouched. Though they disagree on when to act – targets range from this year to 2016 – the statement signals the moment has finally come within striking distance.

There is no longer any reasonable expectation that the Fed has any interest in accelerating the pace of the recovery to more quickly alleviate poor labor market conditions. Barring a sharp change in economic conditions, the Fed is headed in only one direction.

Finally – and I don’t think that many caught this – toward the end of the press conference, Yellen explicitly states that the higher term-premiums triggered by the tapering discussion hurt economic activity by slowing the housing recovery.  But then she credited the move with reducing financial instabilities.  In other words, she willingly traded growth for financial stability.  Something to think about as equities plow higher.

Bottom Line:  If you focus on the “low rates for a long time” language, you walk away with dovish interpretation.  If you focus on the implications of the end of the Evans rule on the Fed’s inflation target, I think you can walk away with a hawkish interpretation.  Moreover, if you believe that 2% is now a ceiling, you probably should think the risk of inflation triggering a Fed response is higher than under the Evans rule, and adjust your forecast accordingly.

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