Policy, U.S.

Is the Fed in Play (again)?

March 24th, 2014 | By Nick Sargen


  • At her first FOMC press conference as Fed Chair, Janet Yellen surprised market participants by suggesting the Fed could consider hiking interest rates as soon as six months after it completed its current tapering operation. This would move the timetable for Fed tightening to the second quarter of 2015. Previously, the market had been pricing in the first rate hike in the second half of the year.
  • At the same time, the Fed's FOMC policy statement dropped the 6-1/2% unemployment rate and 2-1/2% inflation rate thresholds. Henceforth, guidance will be more qualitative and less quantitative.
  • Our own take is that market participants had become complacent that the Fed was unlikely to tighten before the second half of 2015. This left the front part of the yield curve vulnerable to the surprise announcement.
  • We are unsure exactly when the Fed will begin raising rates and are focusing on the economy and jobs creation. Bond yields will likely move higher this year as the economy gains traction, with the 10 year Treasury yield headed for 3.5%.

The Fed Alters its Guidance

Prior to this week's FOMC meeting, market participants expected the Fed would continue to taper its bond purchase program, but investors were unsure whether the Fed would alter its forward guidance about tightening monetary policy. The bond market's initial reaction to the FOMC minutes was neutral, as the minutes confirmed the Fed would scale back bond purchases by an additional $10 billion per month to $55 billion.

At the same time, the statement dropped language about a threshold unemployment rate of 6-1/2% for determining when to raise short-term interest rates. The statement indicated that henceforth the FOMC would take into account a wide range of information, including various measures of labor market conditions, inflation, and financial market conditions. It noted that even after employment and inflation are near mandate-consistent levels, conditions may warrant keeping the federal funds target below levels the Committee views as normal in the long-run for a considerable period.

While some FOMC members have nudged their forecast for the federal funds rate upward, the main surprise occurred in the Q&A session, when the Fed Chair offered the following explanation of what the FOMC meant by the term considerable period:

"…this is the kind of term it's hard to define, but, you know, it probably means something on the order of around six months, or that type of thing."

The bond market sold off on the news, with the front-intermediate part of the curve rising more than the long end.

In light of this, market participants are now less confident that the Fed will wait until the second half of 2015 to begin raising rates. Investors are also waiting to see if the Fed Chair will clarify her answer in subsequent press conferences.

Stay Focused on the Economy and Jobs

My own assessment is to not read too much into Yellen's response, and to stay focused on how the economy and job situation is evolving, as this will ultimately drive monetary policy and bond yields. Based on information coming out of the FOMC meeting, the Committee believes the recent slowdown is temporary and weather related, and it expects the unemployment rate to trend lower partly due to reduced labor force participation. The clearest indication that the economy is on solid ground would be further declines in unemployment and underemployment rates that are accompanied by strong growth in nonfarm payrolls – say, in the vicinity of 200,000-250,000 workers per month.

One reason for focusing on job creation is that it would underpin consumer spending, which accounts for 70% of GDP. During the past few years, households have responded to the low interest rate environment by stepping up their purchases of automobiles and durable goods. However, spending on services has lagged, as households lack the wherewithal to accelerate overall spending. Increased job creation is critical, because it would boost personal disposable income growth as well as consumer confidence. Also, as businesses see an increase in consumer spending, they are likely to respond by hiring more workers and by increasing capital spending – the so-called "accelerator" effect.

While the pace of real GDP growth may have slowed to about 2% annualized in the first quarter from 3%+ in the second half of 2013, I look for the economy to re-accelerate in the balance of this year. The private sector of the economy – consumer spending, residential housing, business investment and net exports – has sustained this pace for the past three years, but tax increases and sequestration of government spending have resulted in lower overall growth. As the effects of "fiscal drag" and a severe winter wane, the economy appears poised to resume growth of about 3%.

Implications for Interest Rates

If this view is correct, I would expect the Fed to begin raising interest rates around the middle of next year and thereafter to move in gradual increments of 25 basis points a quarter. Bond yields are likely to move in advance of any Fed rate hikes, and I look for the yield on the 10 year Treasury to close this year in the vicinity of 3.5%. Should the economy grow faster –say 4% – the date of Fed tightening would occur earlier and bond yields would end the year higher. Conversely, if the economy stayed sluggish and grew about 2%, the opposite would hold.