The Fed & Traditional Policy
The Federal
Reserve’s traditional monetary policy tool is the federal funds rate. The Fed encourages economic growth by
lowering the federal funds rate and attempts to slow growth by raising the
rate. Since the financial crisis in late
2008, the Funds rate has been between 0.0%-0.25%; this is known as being stuck
at the “zero bound.” Since then, the
economy has been in a liquidity trap, the system continues to be overleveraged,
and there is a greater desire on the part of borrowers to deleverage rather
than increase borrowings.
The Fed & Extraordinary Policy Measures
The Taylor
Rule, a widely followed “rule” regarding interest rate manipulation, called for
a negative Funds rate of -2.0% from 2009-2011.
Since it is not possible to create a negative funds rate, the Fed has had to utilize other, less traditional stimulus tools in this environment.
One of these tools,
Quantitative Easing (QE), expands the feds balance sheet through asset
purchases in the open market. By doing this, the Fed attempts to lower long
term interest rates. The fed has begun
to taper these purchases, however, as the continued efficacy of QE has come
into question and some argue that the economy is improving. Another tool used by the fed is called
Forward Guidance. Through Forward
Guidance, the Federal Open Market Committee (FOMC) attempts to communicate where
they think monetary policy will be in the future. This is similar to “jawboning,” where the Fed
talks down long term rates by giving guidance about potential rate action in
the future.
A Brief History of Forward Guidance
Below is a brief history of the
feds Forward Guidance taken from the Fed’s statements after FOMC meetings. This
appeared in the March 14, 2014 MarketWatch from the Wall St Journal:
1. 12/16/2008: First Mention “Weak
economic conditions warrant exceptionally low levels of the fed funds rate for
some time.”
2. 8/9/2011: Added Specific Date “are
likely to warrant exceptionally low levels for the fed funds rate at least
through mid-2013.”
3. 1/25/2012: Extends Date “are
likely to warrant exceptionally low levels for the fed funds rate at least
through late 2014.”
4. 9/13/2012: Extends Date Further “are
likely to be warranted at least through mid-2015.”
5. 12/12/2012: Adds Unemployment Goal “will be
appropriate at least as long as the unemployment rate remains above 6.50% and
inflation is not more than 2.50%.”
6. 12/18/2013: Continues After End of QE “for a
considerable time after the asset purchase program ends.”
7. 3/19/2014: Drops Unemployment Goal “likely will be appropriate to maintain the
current target range for the fed funds rate for a considerable time after the
asset purchase program ends.”
The primary lesson to be taken
from this history is that the Fed reacts to incoming data concerning the
economy, and forward guidance is not set in stone. They have sought to provide guidance to keep
long term rates low, but they have revised their comments and forecasts several
times since the financial crisis. They
have consistently overestimated the strength in the economy and the need for
monetary stimulus.
Connecting The Dots
The chart below shows the federal funds rate forecasts by the 16 members of
the FOMC from the March 19, 2014 meeting.
There is consensus to keep rates low through the rest of 2014, but the
vast majority sees rates higher by the end of 2015. Yellen recently commented that rates would
stay low through the middle of next year.
However,
when asked about the “dots” moving higher, she said we should not pay too much
attention to the dots (even though the Fed is publishing them to give us
guidance.) Her dovish comments have created uncertainty in the markets and bring
into question the usefulness of Forward Guidance.
Forward Guidance Has Limited Value
We are in
agreement with Yellen about the value of watching the dots. The Fed has been providing guidance for the
last 5 years. They have consistently
over-estimated the growth rate in the economy and have over-estimated inflation
as well. The dots have alluded to rate
increases for the last 2 years, but this has not been the case. We believe it would be better to focus on the
growth rate of the economy and inflation expectations. The chart below shows projected economic
growth by the same 16 members of the FOMC.
They have overestimated growth for this year and show it peaking at the
end of next year. They are forecasting
growth in the longer run of 1.8% to 2.4%.
These forecasts of sub-par long term growth and significantly higher
short term rates are inconsistent with each other. During the last few years the Fed has
expanded its balance sheet and fought diligently in an attempt to get growth up
to trend. It seems unlikely they will
raise rates if growth is even slower in the future.
Taylor Rule Revisited
Considering
subdued inflation expectations, relatively high unemployment, and uncertainty
regarding the future growth prospects of the economy, many question why the fed
would consider raising rates. Perhaps the best explanation for the committee’s
higher rate guidance is that the Taylor Rule currently says the Fed Funds rate
should be about 1.0%, as shown in the chart below.
Conclusion
Future Fed
actions are data dependent. The rate of
economic growth and inflation expectations will determine the level of interest
rates. Similar policies in Japan have led
to sub-par growth and low interest rates for the last 20 years. Past and current Fed action has likely drawn
out the process of deleveraging in our country and will lead to below trend
growth and relatively low rates for a long time. Fixed Income investors would be wise to
monitor the economic data, and pay less attention to forward guidance.
