How ‘patient’ is Yellen?

Gavyn Davies

Feb 24 06:00

When Federal Reserve chairwoman Janet Yellen gives evidence to the Senate Banking Committee on Tuesday, she has an opportunity to speak above the heads of the financial markets to Congress and the American people. There is pressure in the Senate to bring the Fed under Congressional “audit”, something that almost everyone in the central bank abhors. So Ms Yellen’s main message is likely to be about how well the Fed has done in recent years, focusing on the generally good out-turns for unemployment and inflation.

The markets, however, will probably ignore most of this important stuff. Instead, they will focus attention on something which is intrinsically unimportant for the economy as a whole — the likely date of lift-off for short-term interest rates.

The Fed’s Open Market Committee is often impatient about the markets’ obsession with this date, arguing that this is irrelevant compared to the Fed’s wider message on the intended path for interest rates over the next couple of years. But investors know that a lot of money can be lost by getting the lift-off date wrong. And, if the FOMC is so unconcerned about this minor detail, why do they focus so much attention on it in their regular meetings?

The Fed’s main message is that the lift-off date will be determined by data, with a raft of releases on inflation and the labour market likely to be weighed in the overall balance. But they have muddied this simple message by giving an unnecessary further piece of guidance that depends on the calendar, not on the data. Here it is, as it first appeared in December 2014:
As progress in achieving maximum employment and 2 per cent inflation continues, at some point it will become appropriate to begin reducing policy accommodation. But based on its current outlook, the Committee judges that it can be patient in doing so. In particular, the Committee considers it unlikely to begin the normalisation process for at least the next couple of meetings. This assessment, of course, is completely data dependent.
That was Ms Yellen’s opening statement in her press conference, fully scripted in advance. The key piece of code is the word “patient”. This gives the firm guidance that there will be at least two clear meetings without a rate rise, unless the data develop in some totally unforeseen manner. Note that this code is different from the 2004 use of the word “patience”, which referred to only one clear meeting, as proven when rates were actually raised in June 2004 (see Tim Duy).

The “patient” attitude was reaffirmed in the January FOMC meeting, which means that lift-off is very unlikely in the March or April meetings. That presents no problem, but if “patient” is left in the statement in March, that would rule out a rate rise in April or June, which is too long for the hawks to stomach. Therefore they want to remove “patient” next month (see James Bullard).

The doves, however, made it clear in the January FOMC minutes that they are worried about removing “patient” in March, because the “two meetings” rule would then be used to price in a rate rise in June, with almost complete certainty. The doves are not ready to go that far at present. Here are the January minutes:
Many participants regarded dropping the “patient” language in the statement, whenever that might occur, as risking a shift in market expectations for the beginning of policy firming toward an unduly narrow range of dates. As a result, some expressed the concern that financial markets might overreact, resulting in undesirably tight financial conditions. Participants discussed some possible communications by which they might further underscore the data dependency of their decision regarding when to tighten the stance of monetary policy.
This begins to sketch out a viable solution to the problem. The FOMC could drop the word “patient” in March, but spell out much more clearly that this does not set any fixed timetable for the first rate rise. So they would remove the “patient” language, but also remove the “two meetings” interpretation at the same time.

In doing this, they might point to the fact that Ms Yellen has always said “at least” two meetings. The markets have never paid any attention whatsoever to the phrase “at least”, but the Fed could forcibly remind them that the words have always had an important meaning. Ms Yellen would not be forced to eat her words, always an important advantage for a central banker.

Exactly what language the FOMC might use to ram this home is unclear, but the Fed’s wordsmiths are nothing if not inventive (as well as verbose on occasions). The upshot would be that the Fed would be opening an option to announce lift-off in June at the earliest, while also retaining the option to delay until a later meeting, if the data work out that way. That, I think, is the message they want to convey at present.

How would the markets react to this? By opening the possibility of a June lift-off, there would probably be a sell-off at the front end of the money market curve, but there would be some uncertainty, so the sell-off may not be huge. After the announcement, the front end would become very sensitive to future data releases. That is what the Fed wants, instead of an “unduly narrow range of dates” for lift-off.

It is not clear whether Ms Yellen will do any of this on Tuesday. She might well prefer to wait until her March press conference.

Does any of this make any sense? Tim Duy again: “If you think this is a dumb way to manage monetary policy, you are correct.”

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