Fed to guide on rate hike path with fresh language, forecasts

Washington (Dec 11)  Federal Reserve Chair Janet Yellen next week has to decide not only whether to raise interest rates for the first time in a decade, but also how to assure markets on the likely path of future rate hikes.

The central bank has held short-term borrowing costs near zero for seven years and the last thing policymakers want is for their first rate hike to trigger expectations for future increases that could knock economic growth off track.

Traders currently expect the Fed to raise interest rates two or three times next year. Fed officials have used quarterly projections to flag a slightly faster pace of increases, but fresh forecasts to be released next week are expected to hew more closely to the market's view.

The forecasts may also show policymakers are banking on slower long-term economic growth and for interest rates to top out at a lower level than was historically the case.

So while Yellen and her colleagues say their interest-rate decisions will be "data-dependent," they are also keen to keep markets calm by showing they see little need to jack up rates at the slightest hint of economic overheating.

"I know that everybody says, 'will she or won't she,'" San Francisco Fed President John Williams told reporters last week.

But "there's a whole path of rates for the next couple years. There’s also the whole decision of how to communicate not only any decision that we make — whether to raise rates or not –- but also having to communicate, what does that mean for policy in the future?", Williams said.

Just how the Fed will achieve this delicate balance is unclear, although it will likely include critical tweaks to the language of its post-meeting statement.

"Stronger forward guidance would be a good ingredient in next week's statement, maybe not a calendar date but maybe about where the bar is for the next move," said Carl Tannenbaum, chief economist for Nothern Trust.

 

"If it’s phrased carefully, the markets will get a sense that, absent a strong change in the fundamental results, it could be mid-year before they move (again)."

A pause of three to six months between rate rises is consistent with economists' expectations in a Reuters poll last Friday, after employment growth boosted confidence that the Fed will raise rates in December.

Yellen and other Fed officials have for months been suggesting that rate rises, once begun, will be "gradual". Next week's statement could be tweaked accordingly, rather than repeating the promise of a "balanced" approach to rate increases in the statement from the last meeting.

Yellen may have pointed to a second change in the statement in a speech last week in New York, noting that the Fed will focus on "actual progress" toward the Fed's 2.0 percent inflation goal as it assesses how fast to raise rates.

 

Atlanta Fed president Dennis Lockhart recently signaled a similar approach, flagging "direct evidence" of inflation rising as his hurdle for future rate hikes.

If incorporated into the Fed's statement, such a phrase could signal a go-slow approach on rate increases, at least in the first half of next year, since many economists currently expect falling oil prices and a rising U.S. dollar to continue to keep inflation low in coming months.

Once the effects of cheap oil and a strong dollar fade, the Fed may have room to speed up rate hikes if needed.

FORWARD GUIDANCE

 

The Fed has used forward guidance effectively in the past, most notably in 2011 when it explicitly promised not to raise rates until at least mid-2013, a promise it later extended through mid-2015.

But a lot can go wrong as well. For example, Fed Chair Bernanke's unexpected suggestion in 2013 that the central bank would soon reduce its bond-buying resulted in market volatility.

Similarly, just a few months ago Yellen's comments about weak economic growth in China convinced markets that the Fed would not dare raise rates until 2016.

Importantly the Fed will next week release a new round of economic projections that will help shape expectations for the pace of future rate hikes just as much as the Fed's words in its policy statement.

The median projections in both June and September this year implied four rate hikes over the course of 2016. Investors will watch those projections closely for any change in that path.

"It is far from obvious that the Fed will tighten as fast as it is suggesting today, so that markets might actually be right," Cornerstone Macro economists Roberto Perli said.

Source: Reuters