Dovish Words, Hawkish Forecast

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Today's activity from the Federal Reserve was an odd mix of a slightly more dovish policy statement and a more hawkish set of interest rate projections. It was topped off with the new Fed Chair Janet Yellen's first post-meeting press conference, which simultaneously provided more clarity on when the Fed would eventually raise rates (if the economy behaved as the Fed expects) but less clarity on what would guide the Fed's decisions.

Putting it all together, we haven't changed our outlook on monetary policy, which is that the Fed will probably accelerate the taper of quantitative easing (QE) later this year, ending it around September and start raising short-term rates by the second quarter of 2015.

As expected, the Fed announced it would reduce its monthly purchases of Treasury securities and mortgage-backed securities by another $5 billion each ($10 billion total) to $55 billion starting in April. This follows a tapering of $10 billion announced at each of the two prior meetings in December and January. So the size of the Fed's balance sheet will continue to rise, but slightly more slowly than before.

The Fed made changes to the statement that signal a slightly more dovish outlook for the economy. The Fed thinks the recent slowdown in economic growth may go beyond bad weather. In her press conference, Yellen explained that this simply meant the Fed was retracting the extra optimism it showed in January and was back to the more cautious optimism it held in December. The Fed also added a reference to unemployment remaining "elevated."

The Fed reiterated that the "considerable time" between the end of QE and the start of rate hikes could last longer if inflation remained below 2%. However, at the press conference, Yellen said a "considerable time" should be interpreted as six months. This difference appears to be confusing to some analysts. We think it means that if inflation gradually moves upward, as the Fed now expects, rate hikes will start about six months after tapering ends; if inflation undershoots the Fed's projection, then the interim period will last longer than six months.

As expected, the Fed dropped its reference to begin considering rate hikes when the unemployment rate dropped to 6.5%. But rather than setting a clear new quantitative target, the Fed basically said we'd just have to trust its judgment, and that it would use a "wide range of information" in deciding when to begin those discussions, including data on the labor market, inflation, and the financial markets. If you like discretionary monetary policy – for central bankers to exercise their judgment without clear guideposts – you'll love the Yellen Fed.

The hawkish part of today's Fed decision was in its projection of the future path of short-term interest rates. The median forecast of the members of the FOMC (Federal Open Market Committee) is that the federal funds target will be 1% at the end of 2015 (previously 0.75%) and 2.25% at the end of 2016 (previously 1.75%). Compared to the last projection in December, the new numbers suggest either a slightly earlier start to rate hikes or a slightly more aggressive series of hikes once they start.

But here's where it gets tricky. At the press conference Yellen said not to read much into slight changes in the projected path of short-term interest rates, as that path could change one way or another at each meeting. That may be her way of dismissing the contributions and importance of some of the regional Reserve Bank Presidents and Fed Governors who participate in that public forecast. In other words, she was saying, pay more attention to her statements as well as those of her inner circle, including New York Bank President Bill Dudley and incoming Fed Vice-Chair Stanley Fischer.

The one dissent from today's Fed's statement was by Minnesota Bank President Kocherlakota, who wanted to make it clearer that the Fed wants inflation to get back to 2% and thinks the statement will foster "policy uncertainty." We'll have to wait to see the minutes of the meeting, but we're guessing he didn't like the more subjective determination of when to raise rates and would have preferred more exact numerical targets for both inflation and unemployment.

At the press conference, Yellen mentioned a few labor market indicators she'll be watching in addition to the jobless rate. These include the more comprehensive U-6 measure of unemployment (which includes part-timers who say they want full-time work, as well as discouraged workers), the labor force participation rate, the "quit" rate, and wage growth.

Look for the markets to pursue more clarity from the Fed over the next couple of weeks. In the meantime, the tapering of QE will continue and we expect economic growth to re-accelerate and equities to move higher before the next meeting at the end of April.

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Posted on Wednesday, March 19, 2014 @ 5:41 PM

These posts were prepared by First Trust Advisors L.P., and reflect the current opinion of the authors. They are based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.