Much has been said about Yellen’s Freudian slip involving the “6 month” considerable period language, which as we pointed out earlier, is said to have been the catalyst that sent stocks sharply lower just after 3 pm when it was uttered. However, in reality all this statement suggests is a rate hike some time in mid-2015, half a year after when QE is said to have ended, which if one listens to the market experts, is what is supposed to be priced in (of course, what the experts won’t tell you is that the market wants its cake and endless liquidity injections by the Fed too). However, one thing that was far more unexpected and certainly remained unexplained by Yellen, is the curious case of the Fed dots, or the estimations by the individual committee members, of where they see rates at the end of 2016. What was surprising here was the sharp upward jump from 1.75% as of December to 2.25% currently.What is even more inexplicable, is that the Fed hiked its rate forecast even as it lowered its GDP projections for the next two years. Why? Not even Janet Yellen could answer that.
Some further thoughts from SocGen on this latest example of just how clueless the Fed is when it comes to the signals it sends about the future.
Had it not been for the dots, market participants probably would have interpreted today’s FOMC statement and Fed Chair Yellen’s press conference as sufficiently dovish. Yet, seeing the FOMC median rate forecast for the end of 2016 rise from 1.75% to 2.25% singlehandedly rendered all else irrelevant. Are markets justified in placing so much faith in the dots? After all, they are pre-determined ahead of the meeting, reflect the views of both voting and non-voting members and are not subject to a vote. While we question the erratic movement of the dots that seems disconnected from the FOMC’s economic projections, the dots do matter. After all, they reflect an unbiased and current view of what current and future voters see as the appropriate rate setting.
The curious drift of the dots
The big shocker today was not that the Fed abandoned its 6.5% unemployment rate threshold, but that is moved the dots, and not by an insignificant amount. The FOMC’s median fed funds rate forecast for the end of 2016 increased from 1.75% to 2.25%, with the end-of-2015 target now at 1% (up from 0.75%). The curious aspect was that this revision looks out of synch with the Committee’s economic projections which did not change materially since December. To be precise, participants reduced their average GDP forecast by 0.1% (to 3.1%) for this year and by 0.05% (to 2.75%) for 2016, but revised down their unemployment rate trajectory by about 0.2%. These revisions were accompanied by similar movements in long-term growth and unemployment estimates, suggesting little change in the Fed’s assessment of projected slack. As a result, the Committee’s inflation forecasts were largely unchanged.
So why the sudden shift in the dots? Even Yellen herself couldn’t explain it, replying that she can’t speak for “why people write down what they do”. Instead, she tried to downplay the upward drift, saying that it was only modest and underscoring that the FOMC was still projecting a large undershoot relative to the prescribed fed funds rate. For clarification, the dots represent forecasts brought to the meeting by all participants, both voting and non-voting. They are effectively decided ahead of the meeting. As such, Yellen doesn’t have any control of the dots and they are not explicitly decided or coordinated by the Committee. In this context, today’s move looks genuinely unintentional.
Despite Yellen’s best efforts to downplay the dots, markets have taken them to heart and repriced 2016 fed funds futures by 25 basis points. Are they right to do so? Probably. While we question the erratic movement of the dots (see chart 1), they do reflect the latest view of all current and future voters about the appropriate level of the fed funds rate. More importantly, the drift was not caused by one or two outliers but rather by a lot of reshuffling in the middle (see chart 2). Therefore it seems to reflect a real change in the underlying view about the appopriate policy setting.
Forward guidance enters vague territory
In what was largely overshadowed by the dots, the FOMC did take a significant step in overhauling its forward guidance. As expected, the Committee abandoned all economic thresholds and replaced them with qualitative guidance. The timing of the liftoff in the fed funds rate will now depend on “measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments”. That’s as vague as it gets. The Committee does provide two additional pieces of information by (1) suggesting that rates will be at zero for “a considerable time after the asset purchase program ends”; and (2) promising that it will keep rates below levels viewed as normal even after employment and inflation are near mandate-consistent levels. In other words, the Fed still promises to undershoot on rates, or overshoot on the amount of stimulus for a long time to come and by a wide margin. This was the message that Yellen tried to push very strongly during the press conference, but convincing the markets may take more effort on her part.
Erratic dot movements + vague guidance = more rate volatility
One of the outcomes of today’s shift to qualitative guidance will be increased volatility in rate expectations between FOMC meetings. Market participants clearly base their expectations for the fed funds target on the dots, and forward guidance is supposed to tell them how the dots will change in response to the data. Unfortunately, the new language provides very little information in that regard. And, the erratic and unexplained movement of the dots themselves does not help either. The next set of projections will be published in June, and until then, we are all flying with limited visibility.
In retrospect, perhaps it is a good thing the Fed no longer is providing forward guidance – if anything, it likely would have both bonds and stocks soaring to all time highs at the same time, on two completely contradictory yet parallel indicators about the future state of the economy, in what is becoming a glaring example of just how horrible the Fed is at not only predicting the future, but telegraphing how it plans to get there.