Fed signals mid-2015 rate hike, but it all depends on the data

Research Department Fed signals mid-2015 rate hike, but it all depends on the data December 18, 2014 The Federal Open Market Committee sent a strong signal that it expects to tighten monetary policy in mid-2015. The Fed said it would be patient in deciding when to raise interest rates, adding that the overall outlook hadn t much changed from earlier assurances that rate will saty low for a considerable time. Chairman, Janet Yellen, explained that patient meant that the bank was unlikly to raise rates for at least a couple of meetings. That would mean April next year at the earliest. Fed official now see a slower pace interest rate rises next year, with a median forecast for Fed funds rates of 1.125% for 2015. They also moved predictions for unemployment and inflation down, but indicated that low inflation is transitory. The dollar appreciated againsts several of its peers while U.S. stocks extended early gains and Treasury bond prices fell as investors are reassured that the Fed is not going to raise rates until the second half of 2015. The DJIA was up 288 points or 1.7% higher, while the 10-year Treasury yield was up 8 basis points to 2.14%. The committee voted 7-3 in in favor of Wednesday s statement. Two of the dissents coming from the hawkish side - Dallas Fed President Richard Fisher and Philly Fed chief Charles Plosser - and the third from the dovish side courtesy of Minneapolis Fed President Narayana Kocherlakota, who was worried about downside risks to inflation Fed sent a strong signal that it expects to tighten monetary policy in mid-2015 The US Federal Reserve took a tentative step toward raising short-term interest rates in 2015, but at the same time exposed its skittishness about signaling a historic move away from easy-money policies in place since the global financial crisis. 1

In a statement Wednesday after a two-day policy meeting, the Fed broached the prospect of beginning to normalize the stance of monetary policy, the most direct formal reference to raising rates it has made in years; emphasising that the Committee will be patient in judging when to start raising rates, in new language designed to reassure markets that rate rises are not imminent. This new language does not represent a change in our policy intentions and is fully consistent with our previous guidance that rates would stay low for a considerable time, said chairwoman Janet Yellen in her post-meeting press conference. Yellen, explained that "patient" meant the bank was unlikely to raise rates for "at least a couple of meetings", signalling that the Fed does not expect to raise rates until its April 2015 meeting at the earliest. Rates have been held near zero since December 2008 and since then the Fed has offered assurances that they would stay low amid low inflation and elevated levels of unemployment. Yellen also made it clear that the coming hiking cycle will not be at a measured pace of 25 basis points hike per meeting as in 2004/2005, stressing that any change in policy will depend on the economic data, as she has done repeatedly since taking over as Fed chair. The US economy has been growing strongly. In recent months the US economy has enjoyed its best run of data since the end of the recession in 2009, including jobs growth of 321,000 in November, as consumers start responding to a plunge in oil prices. However, shrinking economic growth rates in developing countries, most importantly in China, and political instability in Russia and the Middle East have undermined confidence that this growth can persist. Investors were reassured that Fed will not hike rates for a considerable time: Fed officials went into the meeting amid a backdrop of volatile financial markets, featuring sagging bond yields and slumping oil prices. Investors had been hoping the Fed would keep the "considerable time" phrase in its statement. By doing so, it appears that the Fed is signaling that it is unlikely to begin raising interest rates until sometime in the summer of 2015 or later. Stock prices sharply extended gains when a reference to the considerable time assurance reappeared in the Fed s statement. They fell when Fed Chairwoman Janet Yellen suggested a move after two meetings is possible, and then shot up again. The Dow Jones Industrial Average leapt 288 points, or 1.69%, to settle at 17356.87, its biggest gain in 2014. The market moves, taken together, amounted to a vote of confidence that the Fed and economy were on track. 2

Downward pressure on inflation is transitory : With unemployment down to 5.8% and falling fast, the Fed is preparing for interest rate rises next year. But the economy s strength is offset by inflation running well below the Fed s goal of 2%. As a result of the plunge in oil and gas prices, consumer prices rose 1.3% last month, their slowest rate in nearly six years. Excluding volatile energy and food prices, the so-called core inflation rate is 1.7% -- still below the Fed's target of around 2%. The Fed said Wednesday though that it expects the impact of lower energy prices to be "transitory." Yellen acknowledged that the rate of inflation could remain low for a while because of what's happening with oil prices but that prices should move back up over time. Yellen s dismissal of low inflation as transitory, signals that the Fed is willing to look past low inflation towards raising rates. Divisions over interest rate outlook, but Fed officials forecasts see slower pace of rate rises: Three Fed officials dissented at the meeting, all for different reasons, a sign of the discord that looms as the Fed chairwoman tries to chart a course away from zero interest rates. A three-dissent vote hasn't happened since 2011. Dallas Fed President Richard Fisher said rate increases might need to come sooner than the Fed plans. Minneapolis Fed President Narayana Kocherlakota said the Fed isn t putting enough weight on the risks of low inflation. And Philadelphia Fed President Charles Plosser wants the Fed to stop giving time-linked guidance about its rate plans. However, Fed officials choices won t get easier in the months ahead. In forecasts released with the statement, officials said they expected rates to end up anywhere between 0.375% and 4% by the end of 2016; as the 17 officials projected 13 different points where interest rates might end up. While there is no clear consensus on the outlook in two years, their expectations for the year ahead are more clear. Fifteen of 17 policy makers 3

said they expected to raise short-term interest rates in 2015 and their median estimate put short-term borrowing rates at 1.125% by end of 2015. The median rate estimate for 2016 was 2.5% and for 2017 was 3.625%. Those estimates are all modestly lower than the Fed projected in September, meaning that even though officials continue to expect to move rates up next year, they see a very gradual approach once they start. Fed lowers unemployment and inflation projections: The Fed made almost no change to its growth forecasts projecting that the domestic economy would grow at a rate of 2.8% in 2015, but moved its predictions for unemployment and inflation down. The FOMC now expects an unemployment rate of 5.25% by the end of 2015, instead of 5.5%. In the same year, it expects inflation of 1.3%, instead of 1.75%. New Fed Projections Q4/Q4, % 2014 2015 2016 2017 Longer Run Change in real GDP 2.3 to 2.4 2.6 to 3.0 2.5 to 3.0 2.3 to 2.5 2.0 to 2.3 Sep projection 2.0 to 2.2 2.6 to 3.0 2.6 to 2.9 2.3 to 2.5 2.0 to 2.3 Unemployment rate 5.8 5.2 to 5.3 5.0 to 5.2 4.9 to 5.3 5.2 to 5.5 Sep projection 5.9 to 6.0 5.4 to 5.6 5.1 to 5.4 4.9 to 5.3 5.2 to 5.5 PCE inflation 1.2 to 1.3 1.0 to 1.6 1.7 to 2.0 1.8 to 2.0 2.0 Sep projection 1.5 to 1.7 1.6 to 1.9 1.7 to 2.0 1.9 to 2.0 2.0 Core PCE Inflation 1.5 to 1.6 1.5 to 1.8 1.7 to 2.0 1.8 to 2.0 Sep projection 1.5 to 1.6 1.6 to 1.9 1.8 to 2.0 1.9 to 2.0 Source: Federal Reserve 4

FOMC Statement December 17, 2014: Information received since the Federal Open Market Committee met in October suggests that economic activity is expanding at a moderate pace. Labor market conditions improved further, with solid job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources continues to diminish. Household spending is rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow. Inflation has continued to run below the Committee's longer-run objective, partly reflecting declines in energy prices. Market-based measures of inflation compensation have declined somewhat further; survey-based measures of longer-term inflation expectations have remained stable. Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators moving toward levels the Committee judges consistent with its dual mandate. The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced. The Committee expects inflation to rise gradually toward 2 percent as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate. The Committee continues to monitor inflation developments closely. To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored. However, if incoming information indicates faster progress toward the Committee's employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run. 5

Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Loretta J. Mester; Jerome H. Powell; and Daniel K. Tarullo. Voting against the action were Richard W. Fisher, who believed that, while the Committee should be patient in beginning to normalize monetary policy, improvement in the U.S. economic performance since October has moved forward, further than the majority of the Committee envisions, the date when it will likely be appropriate to increase the federal funds rate; Narayana Kocherlakota, who believed that the Committee's decision, in the context of ongoing low inflation and falling market-based measures of longer-term inflation expectations, created undue downside risk to the credibility of the 2 percent inflation target; and Charles I. Plosser, who believed that the statement should not stress the importance of the passage of time as a key element of its forward guidance and, given the improvement in economic conditions, should not emphasize the consistency of the current forward guidance with previous statements. 6

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