MacroScope

The limits of Federal Reserve forward guidance on interest rates

The ‘taper tantrum’ of May and June, as the mid-year spike in interest rates became known, appears to have humbled Federal Reserve officials into having a second look at their convictions about the power of forward guidance on interest rate policy.

Take James Bullard, president of the St. Louis Fed. He acknowledged on Friday that the Fed’s view of the separation between rates guidance and asset purchases had not been fully accepted by financial markets. “This presents challenges for the Committee,” he noted.

A decision to modestly reduce the pace of asset purchases can still leave a very accommodative policy in place to the extent forward guidance remains intact.

The Committee needs to either convince markets that the two tools are separate, or learn to live with the joint effects of tapering on both the pace of asset purchases and the perception of future policy rates.

San Francisco Fed President John Williams also recently outlined some of the drawbacks on relying too greatly on promises of future behavior.

Two Fed financial stress measures show conditions still easy

Composure restored. Despite gut-clenching stock market swoops and a violent 100 basis point upward spike in 10-year bond yields since the Fed’s June 19 meeting and press conference with Chairman Ben Bernanke, financial conditions are still very easy.

That ought reassure officials at the U.S. Federal Reserve that some normalcy has been restored in financial markets after the abrupt reaction to their decision to signal they would scale back bond purchases later this year.

A persistent upward scramble in yields and mortgage rates could chill spending and investment, potentially undermining economic recovery.

To ‘taper’ or not to ‘taper’? Fading the Fed semantics debate

Is Federal Reserve Chairman Ben Bernanke avoiding the word “taper” in order to temper expectations that the U.S. central bank will ratchet down its massive bond buying program? This is one view that’s been widely bandied about in recent days.

But then why is it that the Fed officials who are most eager to “taper” have pretty much stopped using the word, too?

The last time Dallas Fed President Richard Fisher used the “T” word in a public speech was in February. But there’s no evidence at all that he’s backing off from his support of the idea. He’s been adamant the Fed should not yank the punch bowl away (or, in his words, go from Wild Turkey to cold turkey) but should gradually reduce stimulus.

CME Group, home to bets on Fed policy, scrambles to keep watch

These days, it seems, everyone is trying to keep up with shifting market expectations for the Federal Reserve’s monetary policies. CME Group’s Fed Watch, which delivers a snapshot of those expectations based on futures tied to the Fed’s target for short-term rates, is no exception.

Rate futures traded at CME have dived since Fed Chairman Ben Bernanke said last week that the U.S. central bank may decide to cut back on its purchases of Treasuries and mortgage-backed securities in the next few Fed policy meetings if data shows the economy is gaining traction. CME’s website dutifully translated the drop in rate futures into rising market expectations that the Fed’s first rate hike since 2008 could come in early 2015.

But the site was silent on the likelihood of the Fed raising rates any earlier – it simply didn’t include that data, because as recently as a week ago, the probabilities of a rate hike in 2014 were close to zero. Bernanke’s comments, and some strong data, changed all that. By Wednesday, CME had caught up, adding data on meetings in the second half of 2014. Just in the nick of time: by the day’s end, traders were pricing in a rate hike at the Fed’s December 2014 meeting.

The rationale for a December Fed taper

Vincent Reinhart, a former top Federal Reserve researcher who is now chief U.S. economist at Morgan Stanley, believes the U.S. central bank will begin pulling back on the pace of asset purchases in December. Here’s how he arrives at that timeline:

We believe the Fed is going to need to see four employment reports averaging net gains in nonfarm payrolls of at least 200,000 to justify reducing the pace of its asset purchases. The arithmetic of the calendar would then put the earliest date of tapering/tightening in September, which conveniently for the Fed is a meeting followed by a press conference.

Our economic forecast, however, suggests that there will be more slip-sliding through the soft patch, implying that December is the more likely start.

What to expect from Bernanke testimony and Fed minutes this week

Financial markets this will be keenly focused on congressional testimony from Fed Chairman Ben Bernanke and minutes from the central bank’s April 30-May 1 meeting, particularly given a thin data calendar. The latter may be the more interesting one, since it will offer hints into how far Fed officials are leaning in a direction of curbing the pace of its bond-buying stimulus, potentially late this summer.

The economic backdrop has been just mixed enough to leave policymakers cautious about taking their foot off the gas. Still, if we get a few more months of strength in the labor market, Fed officials may just be able to say “substantial progress” has been made in the outlook for the labor market – their stated precondition for an end to asset buys.

Still, Harm Bandholz at Unicredit says markets should not confuse a debate about tapering bond buys with some immediate reversal of the Fed’s policy of ultra low rates.

SF Fed’s Williams in the driver’s seat

In the barrage of Federal Reserve speakers making the rounds on Thursday, it is notable that San Francisco Fed President John Williams was the one that managed to move markets, allowing the dollar to recover losses. Why did his voice rise above the din? For one thing, he’s seen as a dovish-leaning centrist whose views closely resemble the Bernanke-Yellen core of the central bank.

Plus, he took the oft-abused economy-car analogy in a, er, new direction:

If we were in a car, you might say we’re motoring along, but well under the speed limit. The fact that we’re cruising at a moderate speed instead of still stuck in the ditch is due in part to the Federal Reserve’s unprecedented efforts to keep interest rates low. We may not be getting there as fast as we’d like, but we’re definitely moving in the right direction.

Fed speaks, but does market listen?

Jonathan Spicer contributed to this post

When the Fed adopted thresholds for its low interest-rate policy last December, Fed Chairman Ben Bernanke said they would make “monetary policy more transparent and predictable to the public.” But now that the policy is fully in place, it doesn’t seem that the public and the Fed are predicting the same thing at all. Not even close.

In their policy statement following a two-day meeting that wrapped up Wednesday, Fed policymakers removed any reference to date-based policy guidance, saying only that exceptionally low rates would remain in place as long as unemployment remains above 6.5 percent and inflation is not seen to top 2.5 percent. But as recently as December, the Fed’s statement suggested policymakers did not believe those thresholds would be met until at least mid-2015.

The market, as personified by traders ofU.S.short-term rate futures at the Chicago Board of Trade, believes differently. According to CME Group’s FedWatch, which uses fed fund futures prices to estimate market expectations, traders were pricing in a 55 percent chance of a first rate hike by October 2014 – eight months before the Fed’s forecast last month. Threshold-based policy does not seem to have brought the market and the Fed onto the same page – not even to the same year.

Who said what, when? An unofficial guide to Fed speak on QE3

U.S. Federal Reserve policymakers, fresh from a December decision to ramp up asset purchases to help push down borrowing costs, will this year train a sharp eye on jobs.

A “substantial improvement” in the labor market outlook is a prerequisite for ending the bond-buying program, known as QE3 because it is the Fed’s third quantitative easing program since the Great Recession.

Below is a look at top Fed officials’ views on the asset-purchase program, currently at a monthly $85 billion, as well their take on the Fed’s new vow to keep rates low until unemployment falls to at least 6.5 percent, as long as inflation does not threaten to breach 2.5 percent.

How big will the Fed’s QE3 end up being?

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Polling data courtesy of Chris Reese

We’ll know it when we see it. That’s essentially been the Federal Reserve’s message since it launched an open-ended bond-buying stimulus plan that it says will remain in place for as long “the outlook for the labor market does not improve substantially.” Which begs the question: how much larger is the central bank’s $2.9 trillion balance sheet likely to get?

Minutes from the Federal Reserve’s October meeting point to solid support within the central bank for ongoing monetary easing via asset purchases well into 2013.

A number of participants indicated that additional asset purchases would likely be appropriate next year after the conclusion of the maturity extension program in order to achieve a substantial improvement in the labor market.