From “Isn’t It Ironic? The Outlook for Federal Reserve Policy” by Vincent Reinhart, American Enterprise Institute,
That Yellen may go down in central banking history as “The Great Tightener” appears to pose more than a little irony, perhaps to the coming surprise and irritation of Senate Democrats who signed a letter to the president endorsing her Fed-chair candidacy in 2013. Yet, the shift in policy does not reflect a transformation of her beliefs, but rather their pursuit by different means. Tightening now follows logically from Yellen’s understanding of the economic outlook and the dynamics of the Fed’s policymaking group, the Federal Open Market Committee (FOMC). Hiking the funds rate, even as economic growth disappoints and inflation remains subdued, buys Yellen the credibility with her colleagues and market participants to subsequently tighten slowly.
That is, Yellen positions herself now as a conservative central banker to ensure that she can be a compassionate one later by allowing Fed policy to remain considerably accommodative for a considerable time. Understanding this dynamic requires working through the likely outlook for the US economy, our place in global finance, and the trade-offs involved with getting a disputatious policy committee to agree on a plan for policy firming. This understanding also helps to frame the likely reaction in financial markets and some of the risks to the enterprise.
Central to the coming market response to policy action is the yawning disconnect between current Fed interest-rate guidance and money market futures. As shown in figure 10, the year-end levels of the appropriate federal funds rate reported by FOMC participants (the blue dots) uniformly lie above three-month Eurodollar futures rates (the green line) after this year. Simply put, market participants expect Fed officials to deliver what they say about this year but fall short—way short—subsequently. Indeed, market rates are the furthest below Fed guidance in the long run. An important ongoing conversation is in our future: who is right about rates in the long run, the Fed or investors?
This disconnect between the market and the Fed can be consequential. In contrast, a policy sequence telegraphed in advance, as the 2004–06 firming phase was, need not be associated with a significant market reaction, even if the move turns out to be sizeable. As is evident in figure 11, a 325-basis point increase in the funds rate did not dislodge the 10-year treasury yield from a 1 percentage point trading range. But as already mentioned, there may be unintended consequences if the price of such transparency is suppressing market volatility.
Two common misconceptions about policymakers’ and investors’ rate paths cloud interpretation. First, regarding the dots, FOMC participants are instructed to report the policy rate appropriate for the most likely outcome for the US economy. In the most recent SEP in September 2015, participants separately reported downside risks to the outlook predominated. The inference, therefore, is that the dots are almost aspirational in describing what the FOMC would like to do should the downside risks it fears not eventuate. The policy decision is made weighing all potential outcomes, so one can imagine them refraining from choosing the appropriate policy action for the most likely outcome because of the worrisome weight on bad outcomes with a lower probability.
Indeed, we can do more than imagine that possibility, because it seems a good description of what happened in September 2015. Outsized concerns about dollar appreciation amid global turmoil probably restrained them from doing what they wanted to do—tighten monetary as appropriate in the base case of their forecast. Second, market participants do not usually coalesce to a single, expected policy path but instead similarly weigh a range of possibilities. The difference between Fed officials and investors is that the summary statistic focused on in markets, the path of futures rates, represents an average of the possibilities, not just the most likely one.
To simplify matters, think of the green line giving futures rates as an average, with some weight on the FOMC following the best-case “dot” guidance and the remaining weight on the worse case scenario, in which the Fed never tightens because of fears about the global economy. The market reaction after the upcoming meeting depends on how those current probability weights shift in response to the FOMC’s action, the rationale it offers in its statement, and Yellen’s performance in the press conference.
Do read the whole thing.