Fed’s Journey Into the Wild Blue Yonder
Yellen has communication challenges as she heads to Capitol Hill
By David Reilly
Feb. 20, 2015 1:14 p.m. ET
Patience isn’t a virtue when it is too-rigidly defined by markets.
Federal Reserve Chairwoman Janet Yellen testifies next week before Congress in one of her semiannual trips to Capitol Hill, giving investors another chance to obsess over when the central bank is likely to begin raising short-term interest rates. In addressing questions about the so-called liftoff, Ms. Yellen must take on two communication challenges.
The first is to soften investors’ interpretation of what will happen when the Fed drops the word “patient” from its postmeeting statement. The general view in the markets is that once this occurs, a rate increase will follow two meetings later.
But as the Fed tries to regain a more normal monetary policy stance, it will surely want to get less specific in its guidance. The idea is that investors should be prepared for it to raise or lower rates at any meeting, as used to be the case before the current era of zero rates.
Re-establishing this mind-set is no easy task. As shown by minutes of the Fed’s January meeting, released this week, policy makers fretted that dropping the word “patient” would risk a shift in market expectations for tightening in an “unduly narrow range of dates.” That could cause sharp market moves.
Given the crosscurrents now facing the Fed—continued improvement in the U.S. economy even as the rest of the world slows—it needs more flexibility to act based on the data it receives. Without that, markets may indeed overreact, making the 10-year U.S. Treasury, for example, even more volatile than it has been of late.
The second, and possibly greater, challenge facing Ms. Yellen and the Fed will be to more clearly define what a tightening cycle is likely to look like in a post-zero-rate world. In the past, central-bank tightening was meant to cool exuberance, taking away the proverbial economic punch bowl.
Now, though, the Fed seeks to get back into the business of ordinary, versus extraordinary, monetary policy. That is a different proposition and one that makes a far more cautious approach likely. Rather than a series of rapid-fire rate increases, the Fed will probably pause between moves. And the final resting point for short-term rates may end up well below the 3% to 4% level that would typically be expected.
How the Fed manages expectations on this front is particularly important. The actual economic impact of a quarter-point increase in short-term rates is likely to be minimal given they are near zero today. But a shift in market sentiment could have noticeable, and unpredictable, effects.
Will, for example, investors begin to move out of equities back into fixed-income products, possibly causing market hiccups? On the flip side, will home buyers get more aggressive in hope of getting purchases done before rates spike, spurring housing?
Meanwhile, the Fed will have to contend with the fact longer-term yields are depressed due to the downward pull exerted by central banks elsewhere engaging in quantitative easing, or the buying of government bonds. That raises the prospect of a flattening of the yield curve, which could put U.S. banks’ margins under even greater pressure. It also argues for continued strengthening of the dollar, a possible headwind that again could cause the Fed to proceed slowly.
What’s more, the Fed is venturing into uncharted territory. While many academics, including former Fed Chairman Ben Bernanke, studied the Great Depression and how to address a recurrence of such dire conditions, far less work has been done on what comes after a rescue mission. There simply aren’t many playbooks for exiting an almost seven-year period of near-zero rates.
Getting to the point of liftoff is indeed a fraught process, one the Fed will have to manage gingerly.
The bigger issue for both stock and bond markets, though, may be how much turbulence they encounter once the Fed gets rates back into orbit.
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