As the Federal Reserve (Fed) starts the new year, there is one thing conspicuously absent from its communications: quantitative guidance. This is a notable change. In contrast to the date-based guidance of 2011 and 2012 and the threshold-based commitment of 2013 and 2014, the most recent Federal Open Market Committee (FOMC) statement lacked any quantitative guidance. The FOMC even appeared to retreat from softer forms of forward guidance, as it modified its expectation that rates will stay at zero for a “considerable period” to a weaker statement that it will be “patient” in normalizing policy. At this rate, it is likely that after March, FOMC statements will provide no forward guidance of any kind regarding the first rate hike.
Here is how Fed Chair Janet Yellen explained the reaction function in her December press conference:
“By the time of liftoff, [FOMC] participants expect to see some further decline in the unemployment rate and additional improvement in labor market conditions. They also expect core inflation to be running near current levels but foresee being reasonably confident in their expectation that inflation will move back toward our 2% longer-run inflation objective over time.” (Emphasis added.)
So what is one supposed to do with this subjective statement, and in particular, with the phrase “reasonably confident”? One approach (that we pursue below) is to evaluate the risks around the inflation outlook and make our own assessment of each one’s significance. To preview our conclusion: we think the risks to the inflation outlook are material and will likely cause the Fed to delay rate hikes while it works to develop “reasonable confidence.” As a result, we think the Fed’s first rate hike is unlikely to happen in June, and is more likely to happen sometime toward the end of the year. More importantly, we think the Fed will be responsive to these risks, such that any downside surprise could mean further delays in rate hikes. In this sense, Fed policy, and the front-end of the US yield curve, will be counter-cyclical in 2015.
In this piece, we will discuss four of the most important risks to the Fed’s inflation outlook: (1) falling oil prices, (2) US dollar appreciation, (3) additional easing from the European Central Bank (ECB) and the Bank of Japan (BoJ), and (4) falling global inflation. In each case, there is a plausible argument that any impact on inflation will be mild and transitory, which appears to be the Fed’s base case. However, there is also an argument that the impacts on inflation will be more lasting and pernicious. While these more pessimistic scenarios may not be the base case, they are likely to cause the Fed to be cautious in 2015, and are key in our reasoning that hikes will be somewhat delayed.
For more, read “The Fed Outlook for 2015,” by John Bellows, Western Asset
The Federal Reserve Board (“Fed”) is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The Federal Open Market Committee (FOMC) is a policy-making body of the Federal Reserve System responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The yield curve shows the relationship between yields and maturity dates for a similar class of bonds.
The European Central Bank (ECB) is responsible for the monetary system of the European Union (EU) and the euro currency.
The Bank of Japan (BoJ) is the central bank of Japan and is responsible for the yen currency.
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