Tuesday, 17 July 2018

Shah on the Fed

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Uncharted forward guidance territory will test the Fed’s persuasiveness

Divyang Shah, Columnist

Divyang Shah, IFR Senior Strategist

While markets will initially focus on the post-meeting statement and the FOMC’s projections, Bernanke’s message at the press conference will be the most important factor in fitting all the pieces together.

A start to tapering increases the need for Bernanke to address the issue of the likely path of the fed funds rate with the key message being that policy will stay accommodative and the Fed is in no hurry to return rates to the 4% neutral level despite its unemployment and inflation forecasts.

Remember that back in June the FOMC Committee authorised the chairman to “make an announcement of an approximate timeline for reducing the pace of asset purchases to zero”. Words and forecasts are open to misinterpretation, and the Fed will use the press conference to make sure that markets understand that policy will “remain highly accommodative” even after QE ends sometime in mid-2014.

Likely changes to strengthen the forward guidance should help Bernanke sell the message of accommodative policy despite the Fed slowly moving towards lifting the fed funds rate in 2015. WSJ’s Hilsenrath explained the communications challenge in his latest piece by highlighting how Fed projections for 2016 will see unemployment between 5.2-6.0% and inflation near the 2% target, but a fed funds rate that will stay well below the rough 4% neutral rate. If unemployment and inflation are at their long run levels, then why aren’t interest rates?

The prospect of QE ending around mid-2014 and a forecast of more normal economic conditions in late 2014 to 2015, will make it difficult for markets to believe that Fed will not tighten policy more aggressively. After all, what’s to stop exuberant financial markets from persuading the Fed that they need to be more aggressive for financial stability reasons? It makes sense for Bernanke to use the post-meeting press conference to explain the Fed’s thinking on the likely path for the fed funds rate. The Fed went some way toward revealing its thinking back in July.

The FOMC gave a glimpse of the fed funds path it feels is appropriate in the July minutes when “a number of participants” viewed market expectations on asset purchases and the path for Fed Funds as being “well aligned with their own expectations”. Back then, the NY Fed survey of primary dealers showed that market expectations had shifted toward a higher path for the fed funds rate compared to the April and June FOMC meetings.

At the end of 2016, primary dealers saw the fed funds rate at 2.50% and then for end-2017 3.25%, still well below the 4% level regarded as a neutral rate.

For all the volatility in Treasuries and Eurodollars, the market has digested the Fed’s need to reduce policy accommodation with the near record high on S&P500 highlighting that the liquidity backdrop remains supportive for risk markets.

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