September 24, 2014 | By Scott Minerd, Global CIO
Alan Greenspan once said, “I know you think you understand what you thought I said but I'm not sure you realize that what you heard is not what I meant.” Unlike Greenspan, current Fed Chair Janet Yellen wants to be understood and her message for investors in recent months has been that she would keep interest rates zero bound for a “considerable time” after quantitative easing ends. Her next messaging challenge will likely be to define what “highly accommodative” means.
Waiting on the outcome of September’s Federal Open Market Committee meeting, it seemed at times as if the fate of financial markets depended on whether policymakers kept the “considerable time” language in its statement. In the coming months the market will likely focus its attention on another crucial phrase in the FOMC’s statement, where the committee states that “a highly accommodative stance of monetary policy remains appropriate.”
With the current federal funds rate set at 0 to 25 basis points, what exactly is “highly accommodative”? Is it at the zero bound or at another rate level? The answer to that question is likely to be the next communication challenge for the Fed. Any initial move to raise interest rates will likely be advertised as pre-emptive, and despite the forecasts of the Fed’s “dots,” investors should not expect a fed funds rate of above 1 percent at any stage in 2015—a level the central bank could easily contend is still “highly accommodative.” (It could be argued that any funds rate below 2 percent could be interpreted as “highly accommodative.”) As monetary policy tightens, investors should hope for small steps and a sufficient period between moves to allow the Fed to monitor cause and effect.
The Fed is likely to characterize as “highly accommodative” any funds rate maintained below what policymakers deem to be an equilibrium level, but not necessarily kept at the zero bound. As Yellen stated in a 2005 interview when she was San Francisco Fed president, “monetary policy should be at neutral only when economic conditions are ‘just right.’” The question will be the definition of what is “just right.”
Federal Reserve Bank of New York President William Dudley offered more clues on Monday about the path to tighter monetary policy, telling Bloomberg News that the Fed may allow the economy to “run a little hot for at least some period of time” in order to push inflation back up to its 2 percent target. So long as inflation remains low, the Fed may be willing to tolerate an unemployment rate lower than 5.2 percent. Below target inflation seems likely given the strengthening U.S. dollar, lower commodity and energy prices and the slowing rate of increase of U.S. shelter costs.
While we cannot conclude with certainty what the Fed is going to do, we can see the bias and direction of the Yellen Fed far more clearly than we ever could during Greenspan’s tenure, and “just right” may actually translate into a U.S. economy that otherwise might be termed as overheating.
Financial markets interpreted the Federal Open Market Committee’s latest “dot plot” as hawkish because its median projection forecast the fed funds rate increasing by the end of 2015 to 1.375 percent from its June forecast of 1.125 percent. However, this is skewed by several hawkish FOMC members who will not have a vote in 2015 and so is not a good indication of the thinking of next year’s voting members. The number of 2015 voting members projecting rates below 1 percent increased to four in September from three in June, indicating a more dovish stance among these key FOMC members. In addition, counting only “dots” of 2015 voting members, the median end of 2015 fed funds projection remains at 1.125 percent.
Source: Federal Reserve, Guggenheim Investments. Data as of 9/17/14. The FOMC members assigned to each dot are based on Guggenheim estimates.
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