Fed Meeting: Staying the Course Spooks Markets

During the meeting of the Federal Reserve today, there were no surprises. According to the Wall Street Journal, “The Fed took several actions at the meeting. First, it pulled back to $55 billion from $65 billion its monthly bond-buying program, which is aimed at holding down long-term interest rates in hopes of boosting spending, hiring and growth. It was the third reduction in the bond purchases since December”. Asset purchases, which have been reduced from $85 billion a month, are on pace to be finished this coming October. Tapering and the ending (in the growth of) asset purchases was already priced into the market before the Fed’s meeting. In short, tapering is old news. Although asset purchases will likely be done in October, it remains to be seen how the Fed unwinds its massive balance sheet.

The Fed made some (relatively) more exciting changes with respect to forward guidance. According to the Wall Street Journal, “The central bank also rewrote its guidance about the likely path of short-term interest rates, putting less weight on the unemployment rate as a signpost for when rate increases will start”. As the unemployment rate has decreased to 6.7%, the 6.5% threshold for unemployment has become a less significant data point for policy makers. Furthermore, limitations of the unemployment rate have made it less meaningful as an indication of conditions in the labor market. I have mentioned in previous blogs that changes in the unemployment rate were not accurately portraying underlying conditions in labor markets . For example, an increase in the labor-force participation rate pushed the unemployment rate up to 6.7% in the last employment report. Although an increase in the labor-force participation rate is perceived as good, an increase in the unemployment rate is seen as bad. According to the Wall Street Journal, “It said instead [of the 6.5% unemployment threshold] that the Fed would look at a broad range of economic indicators in deciding when to start raising short-term rates from near zero, where they have been since December 2008“. Therefore, I believe it was a good decision to ditch the unemployment threshold in favor of a larger set of economic indicators.

In addition, the Fed reconfirmed its forward guidance on interest rates. According to the Wall Street Journal, “The Fed took several steps to assure investors that interest rates won’t rise soon and that when rates do start rising the increases will be gradual and limited. For example, the Fed’s official policy statement included a new line noting that officials expect to keep rates lower than normal even after inflation and employment return to their longer-run trends“. Although this policy has been understood for some time, the Fed has finally decided to state this unambiguously. As the Fed continues to taper, most people assume that rate hikes will follow – the question is how soon they will follow. In addition to other factors, the inflation rate is going to be important in determining when interest rates will rise. If inflation remains below target, then rates will remain low long after the bond buying ends.

However, financial markets fell today – possibly due to what was said during the Fed’s meeting. According to the Wall Street Journal, “Even though the Fed’s official policy statement sought to give assurances of continued low rates far into the future and Ms. Yellen played down rate-increase expectations, stock prices fell and longer-term rates on Treasury bonds moved up”. Despite the lack of surprises, the Fed’s meeting managed to somehow cause worry among investors.

Apparently, the source of concern was regarding the perception of imminent rate hikes. According to the Wall Street Journal, “In a press conference after the meeting, Ms. Yellen suggested that interest-rate increases might come about six months after the bond-buying program ends – a conclusion that could come this fall”. Financial markets were not anticipating interest rates to increase in early 2015. After many years of aggressive expansionary monetary policy, the financial markets have become very sensitive to interest rate decisions.

Today’s Fed meeting essentially affirmed that interest rates will begin rising in 2015. Considering that asset purchases will likely end in October 2014, interest rate hikes in 2015 might seem sudden to financial markets. Regardless, I believe interest rates will begin rising in 2015 so financial markets might as well begin pricing that in. According to the Wall Street Journal, “Ten of 16 officials saw short-term rates rising to 1% or more by the end of 2015, with four of them right at 1%. Six officials saw rates below 1% by the end of 2015“. Although Ms. Yellen might have misspoke during the press conference, I think it is good that she was very clear about when interest rates will begin rising. Assuming there are no setbacks, I believe the economy is strengthening to the point where interest rates can begin to rise.