The minutes from the March 18-19 Fed policy meeting were released last week. It was at that meeting when the Fed Open Market Committee (FOMC) voted to reduce QE bond purchases by another $10 billion a month – no surprise there. The FOMC also voted to eliminate the longstanding 6.5% unemployment target for starting to raise interest rates – no real surprise there either.
The minutes indicated that instead of focusing on the unemployment rate, the Committee will focus on “a wide range of information” and “readings on financial developments.” This description is very vague and seems to be a move away from the transparency advocated by former Fed Chairman Ben Bernanke.
This move away from the Fed’s previous indicators under Bernanke’s chairmanship is marked by the substitution of undefined information versus clearly defined statistics in making policy. Markets have grown used to milestone markers dictating the Fed’s next move. How do we set our watches for a ‘financial development’?
The Fed also changed its projection for the Fed Funds rate going forward. While most Fed watchers don’t expect an increase in the Fed Funds this year, the FOMC did increase its rate projections for 2015 and 2016. For 2015, the Committee increased its Fed Fund rate projection from 0.75% to 1.0%. For 2016, they increased the rate target from 1.75% to 2.25%. This move was not expected and therefore came as a negative surprise to the markets.
The stock markets tumbled on the two days after the minutes were released. I have maintained for the last several years that QE significantly helped push stock prices higher. When it first became clear that QE would be “tapered,” I predicted this would be negative for stocks. The change in forward rate guidance and the increase in rate projections for 2015 and 2016 were a disappointment for the equity markets.
At the end of the March 18-19 FOMC meeting, Janet Yellen held her first press conference as the Fed Chair. She emphasized that dropping the 6.5% unemployment threshold did not indicate any immediate change in the Committee’s policy intentions. She suggested that the Fed will keep its eyes on the economy and will alter policy as needed.
The big surprise was when Yellen commented in vague terms that the Fed Funds rate would likely start to rise apprx. six months after the Fed ends its bond purchase program. If the taper of QE continues at the current pace, the bond purchase program could end as soon as October of this year. If so, the first Fed Funds rate increase could come next April or May.
Most Fed watchers agree that the FOMC will begin the rate hikes slowly, presumably with an initial increase of only 25 basis-points. If the first Fed Funds rate increase does not come until May of next year, that means the Fed will have to raise the rate several more times after the initial increase next year to meet its projection of 1% by the end of the year.
And then to get from 1% at the end of 2015 to 2.25% by the end of 2016, the Fed will have to raise the rate several more times that year. If the economy is stronger at that time, I would not rule out a rate increase of 50 basis-points. The markets didn’t like the sound of any of that.
While we have all known that interest rates are going to rise at some point, the information from the March FOMC meeting and the press conference made it more of a reality – and with a fairly clear timetable. However, while the Fed may not begin raising the Fed Funds rate until a year from now, as indicated, that doesn’t mean that interest rates won’t rise on their own even earlier, as you can see in the chart above.
I think this is what troubled the markets most over the last couple of weeks. As of now, the equity markets are rebounding, but it remains to be seen if this correction is over.
The next FOMC meeting will be held on April 29-30, but there will not be a press conference with Fed Chair Yellen afterward.