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Date with the Fed: Some things change, some things don’t

By Jason Martin

Date: Wednesday 25 Jan 2012

Date with the Fed: Some things change, some things don’t

The US central bank, the Federal Reserve, is set to break with tradition on Wednesday and publish interest rate forecasts along with the more customary statement from the Federal Open Market Committee (FOMC) statement and the now almost one-year-old practice of holding news conferences.

Let's award full marks to the Fed for improving communication, and though it is tempting to think of that old French proverb "the more things change, the more they stay the same", in a nutshell, we might simplify things by stating that "some things change, some things don’t".

ON THE AGENDA:

As far as the Fed’s agenda on Wednesday goes, the party starts off with the FOMC statement at 5:30 pm London Time.

Next up at 7:00pm will be the publication of the committee's economic forecasts along with the “novelty” of interest rate forecasts: the publication of two graphs titled “Appropriate Timing of Policy Firming” and “Appropriate Pace of Policy Firming”.

In essence, the first chart will show in which year policy makers think the benchmark rate should rise from zero. The second graph will use dots to show where each FOMC member thinks the Fed funds rate should be in the final quarters of 2012, 2013, 2014 and over the longer run.

The grand finale will kick off just 15 minutes later at 7:15pm, as the Fed's chief, Ben Bernanke hits the microphones to give his now famous “post interest rate announcement” press conference.

THE SAME OLD, SAME OLD:

Now, without denying that the new publication of interest rate forecasts represents a major shift in the Fed’s attempt to achieve transparency through improved communication, few “changes” are expected by the markets.

The experts rule out the possibility of a change in the federal funds target rate (currently 0% to 0.25%) that has now been at historical lows for over three years.

The large majority also expect the Fed to keep a lid on the possibility of a new round of asset purchases. Analysts mostly agree than any further quantitative easing (dubbed QE3 after two previous programmes that left the Fed with $2.3tn worth of bonds and were designed to pump liquidity into the financial system and stimulate economic growth) won’t occur at this meeting.

Some things “never” change, but with regard to those that do …

THE FED’S NEW TOY:

The major market focus today will be on the “novelty”. For the first time in its history the Fed will be publishing relatively detailed information on its members’ forecasts for the future of interest rates.

The Fed first made a bold move of targeting a calendar date for its accommodative policy in August of last year. Since then it has repeatedly promised in its statement to keep interest rates at “exceptionally low levels ... at least through mid-2013”.

The bold emphasis is ours, necessary we feel, because it’s a point that’s been inconveniently skipped over in so many market commentaries. The fact of the matter is that the consensus puts the first rate hike at “some time” in 2014. If the Fed were to feel the same way, that wouldn’t invalidate the prior phrase. Indeed, we could take “at least through mid-2013” as a minimum guarantee for these “exceptionally low” rates.

When actual tightening might occur is probably as varied among the FOMC members as it is amongst the experts, but with regard to the novelty of the rate forecasts, the economists at Bank of Tokyo-Mitsubishi point out that “just seeing that the choice of a year for the first hike in the Fed funds rate goes all the way out to 2016 makes us think there are at least a few members of the committee who don’t want to raise rates until the unemployment rate gets back down to 5% or 6% (currently at 8.5%).” These experts expect some hawkish Fed members to estimate a hike in 2013 and other dovish members to want to keep things on hold until 2015, but their conclusion is that “the weighted average is likely to be 2014”.

Exactly when however is far from clear. Jefferies & Co. predicts “early 2014”, while RBC takes the other end of the year by suggesting that the forecasts will indicate no expected change until “late 2014”. Bank of America points out what is probably most relevant for investors: in their opinion, the market has already priced in expectations that interest rates won’t increase until April 2014.

If this last broker is right, then only a deviation from that expectation invoked by the new forecasts would serve to move the market as it is forced to readjust pricing.

Citigroup emphasises that markets need to understand in any case that these new estimates will be “designed to relay how policy would unfold under highly plausible scenarios.” No one knows the future and a four year prediction for the future path of interest rates seems unreliable at best.

Never mind that the Fed hasn’t always been the best of seers with monetary policy if we consider such “mishaps” as the recent housing bubble or the Great Depression. Citigroup sums it up well when stating that “under normal circumstances, official forecasts of where short-term rates will be several years in the future would be quickly dismissed”.

Another factor that might cast doubt on the reliability of these long-term predictions is brought up by UBS: “Markets may discount whatever long-term projections the Fed makes about interest rates because Fed Chairman Ben Bernanke’s second term ends in January 2014, when he could leave office.” In other words, this changing of the guard would invalidate prior projections.

Capital Economics agrees with Bank of America that market prices currently reflect no rate hike until at least 2014. “In policy terms, this is a historic change. In practical terms, however, the change isn’t going to have any major impact,” the broker says.

QE3?:

Talk of QE3 (the term for a third round of quantitative easing) and the difference of opinion on whether it will (or should) be implemented is nothing new. Neither is the practically unanimous opinion that the Fed will not be announcing it on Wednesday evening.

Most analysts feel it could arrive later this year. However, Miller Tabak expects nothing less than the purchase of $1 trillion in mortgage debt and the broker expects it “now”. Société Générale also expects a programme, but not until the March 13th meeting. The French broker notes that the meeting minutes from December showed that a “number of FOMC members” were in favour of more bond purchases.

On the other hand, RS Investments puts the chances at less than 50% due to recent improvements in the US labour markets. Economists at Standard and Poor’s and Moody’s Analytics don’t rule out the possibility of a new programme but feel it will only happen if Europe goes down the tubes. As long as that doesn’t happen, causing a destabilisation of US financial markets, they point out that the American economy is improving. It’s “still soft but not struggling” according to Moody’s.

Perhaps one of the most interesting points is made in Walter Kurtz’s blog Sober Look. He notes that QE3 is simply the last bullet left in the Fed’s arsenal and thinks the US monetary authority could only use it in the case of a global credit crisis caused by the bankruptcy of a large European financial institution. This is something that, in his opinion, neither the Eurozone nor the European Central Bank will let happen.

More to the point, one might wonder what market panic would ensue if investors felt that the Fed was out of bullets.

AND DON’T FORGET ...

... that amid all the hoop-la, the Fed will be updating its economic forecasts. Bernanke’s economic team previously predicted growth for this year of between 2.5% and 2.9%, but market consensus points to 2.3%. If the Fed were to lower its expectations, that could signal a willingness to do something more for the economy.

However, it’s important to remember that unemployment has been the major focus. After recent improvements in the labour market, the unemployment rate projection could remain stable or even be revised down. This would take the pressure off the Fed to make its next move.

With regard to price stability, there is some speculation that the Fed could provide a specific inflation objective, which “off the record” is thought to be around 1.7% to 2.0%. Yet the Fed seems to have plenty on its plate with the new interest rate projections, so it’s hard to imagine them wishing to make communication (even more) complicated.

Indeed, Bank of America warns that “with all the new information being released, the chance for some communication miscue is high. In time, enhancements to Fed transparency should reduce market volatility, but the transition period could be a bit rocky.”

In fact, T. Rowe Price believes that the Fed “want(s) to get the communications changes out there and get them understood before they do anything else”.

To sum up, the novelty of interest rate forecasts provides an extra spark to what already tends to be a volatile market-moving event but High School economics teaches us that “if you have to forecast, do it frequently”. Whatever estimates the Fed has aren’t set in stone, as possible downward revisions to its economic forecasts might serve to remind us on Wednesday evening.

As with every Fed event, “some things change and some things don’t”. Keep your eyes on the charts.

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