Journey to the Center of the (Fed's) Mind (Sonders)

Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

January 25, 2012

Key Points

• The Federal Reserve opted to keep short-term interest rates on the floor and extended the period of time during which rates are likely to remain near zero.
• Newly published forecasts show slightly better growth, a bit less inflation and a lower unemployment rate.
• Fed Chairman Ben Bernanke got hit with a lot of questions about the risks of extending zero-rate policy for 2 ½ more years.

First, the statement

The Federal Reserve was more explicit in its statement today, which accompanied the finale of the Federal Open Market Committee’s (FOMC) two-day meeting today.

“…the Committee decided today to keep the target range for the federal funds rate at 0 to ¼ percent and currently anticipates that economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”

The reference to 2014 was an extension of the Fed's previous pledge to keep rates low at least until mid-2013. Although several Fed officials have said even further easing (read: quantitative easing round three, or QE3) is needed to revive hiring and housing, there was one notable dissent today: “Voting against the action was Jeffrey M. Lacker [Richmond Federal Reserve Bank President], who preferred to omit the description of the time period over which economic conditions are likely to warrant exceptionally low levels of the federal funds rate.”

The Fed did say it would continue its “Operation Twist” program, which has been extending the average maturity of its $2.6 trillion securities portfolio.

Frankly, I have reservations about the two-and-a-half year span during which the Fed expects to keep short rates effectively pegged at zero. Much can and will likely happen between now and then, be it economic conditions and/or inflation trends. Given that the Fed has often been criticized in the past for being behind the curve, it almost guarantees it will do it again by this effective promise. And, it can also be seen as yet another hit to savers and retirees.

As noted by High Frequency Economics, “they are now too cautious, expecting only ‘modest’ growth as far as the eye can see. We see no mention of the sustained surge in bank business lending, the rebound in survey data, the upturn in every housing indicator and only a tangential reference to the plunge in the pace of layoffs. The markets face two dangers if these emerging trends persist. First, the Fed might have to renege on its ‘promise’—the word ‘likely,’ after all, is not a solemn vow—or, second, they might tighten by reversing QE, while sticking to zero rates. Either way, fingers get burned in the markets.”

Second, the forecasts

Shortly after the release of the FOMC statement, the Committee released expectations of the five Fed board members and 12 district bank presidents. Of these 17 Fed officials, nine expect short-term interest rates to remain below 1% by the end of 2014, while six expect rates to remain at zero into 2015. The Fed also lowered its estimates for growth and inflation this year, a move consistent with its statement as noted above.

These projections are new for the Fed—it’s the first time in FOMC history that it’s explicitly laying out its forecast for growth, inflation and rates. Assuming an increase in rates sometime in late 2013 or 2014, it would be the first rate hike since June 2006. Think about that: as noted below, there are two Committee members that think the first hike should come in 2016—if that’s the case, it would mean a full decade of no rate hikes.

There was no unanimity with regard to the pace at which the Fed should raise rates:

• Three officials believe they should begin rising this year.
• Another three believe they should begin moving higher next year.
• Five say they should go up in 2014.
• Four say 2015.
• And two even believe the first hike shouldn’t come until 2016!

By the way, the Fed

It's estimated that US economic growth, as measured by real gross domestic product, will be between 2.2% and 2.7% (from the fourth quarter of 2011 through the fourth quarter of this year). For 2013, US growth is forecasted to be between 2.8% and 3.2%. (The forecasts are calculated using a “central tendency forecast,” which excludes the three lowest and highest projections.)

As for inflation, it’s projected to drop below the Fed’s newly stated goal of 2%, with the majority of officials expecting inflation in a range between 1.4% and 2.0% through 2014. These are marginally lower inflation projections than those published last November.

And, in keeping with the recent traction seen in job growth, the Fed’s forecasts for the unemployment rate have also ticked down and now sit at between 8.2% and 8.5% for 2012, 7.4% and 8.1% for 2013 and 6.7% and 7.6% for 2015. These forecasts are below the prior forecasts published last November.

(For a more detailed look at the Fed officials’ economic projections, see the full chart in today’s Fed release.)

Third, the press conference

My friend Steve Liesman, from CNBC, asked the first question, and it was a good one. He essentially wanted to know whether the Fed was doubting the economic improvement that’s been seen in the past few months. Bernanke did acknowledge improvement in some areas, but “mixed results” in others; specifically: “We continue to see headwinds emanating from Europe, coming from the slowing global economy.” He also said, “I don’t think we’re ready to declare that we’ve entered a new, stronger phase at this point. We’ll continue to look at the data.”

There were additional questions that got to this subject. One asked whether there was risk of a backlash from the Fed’s new information, particularly by hurting confidence by suggesting the economy is weaker than people think. Bernanke’s response: “Those considerations are outweighed by the need to maintain accommodative conditions,” so it’s attractive for companies to invest and hire, and for people to buy houses.

Bernanke did address the fact that the individual forecasts don’t have names attached to them. He indicated that they aren’t disclosing the identities for a reason—to ensure discussion at meetings and to depersonalize monetary policy.

Bernanke did not escape politics in the questioning, and was asked about the hostility toward the Fed during many of the Republican debates. In particular, he attempted to fight back against the criticism that Fed policy is crushing savers and retirees: “The savers in our economy are dependent on a healthy economy in order to get adequate returns.”

Finally, the Chairman was asked about his confidence in the Fed’s forecasting abilities. At least he was honest when he replied, “Our ability to forecast three and four years out is obviously very limited. Nevertheless we have to make a best guess, a provisional plan,” much like companies do. “It’s certainly possible we will be either too optimistic or too pessimistic,” which suggests the Fed may have to adjust to the realities of the actual data.

We think that’s a real possibility.

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