What’s next in the Fed’s path to normalization?

Below is the final in a series of articles on coming changes in monetary policy. Click here here here for Ion Dan’s comments on the tools the Fed may use to normalize monetary policy. Click here here here for comments on how regulatory issues within the money and repo markets could interplay with interest rate normalization.

The U.S. Federal Reserve’s objectives for monetary policy are maximum employment and stable prices. On inflation, the Fed believes a rate of 2% is consistent with its mandate. The employment objective is more difficult to measure and policy decisions are based on forecasts. In the most recent Summary of Economic Projections (SEP), committee members estimated the longer-run normal rate of unemployment at between 5.2 and 5.5%.

As chart 1 indicates, employment data showed improvement over the last year, but the rate of participation remained low and broader measures, such as U6 , and the Fed’s new Labor Market Conditions Indicator (LMCI) indicate underutilization. Inflation inched up, but personal consumption expenditures (PCE) remained below 2%, while inflations expectations were stable.

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Chart 1: Employment data have improved over the past year, yet much slack remains. Inflation data have remained generally stable

Chart 1: Employment data have improved over the past year, yet much slack remains. Inflation data have remained generally stable

Employment indicators

6 mo avg NFP

U3 unemployment rate

Labor force participation

U6 under-employment rate

LMCI

Inflation indicators

PCE

Core PCE

Fed 5yr inflation

Average hourly earnings

Data: Bloomberg. U3 refers to the total unemployed as a percent of the civilian labor force (official unemployment rate)

The improved unemployment rate surprised members of the Fed and gave ammunition to its inflation hawks as they argued for tighter monetary policy. However, even the hawks’ growth forecasts have been too optimistic. Against this backdrop, there is currently no indication of wage pressures.

In chart 2, we highlight the evolution in the fed funds rate forecast since 2012. The Fed expected an earlier lift-off and a higher terminal rate, but the economy failed to recover in line with the Federal Open Market Committee’s (FOMC’s) growth forecasts, which has led to a reassessment in policy (refer to Chart 3 for more information). A lower terminal funds rate, in our view, corresponds to an acknowledgement of a lower potential for economic growth.

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Chart 2: An evolving fed funds forecast

Chart 2: An evolving fed funds forecast

Data: Federal Reserve

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Chart 3: FOMC projections on several key economic indicators

Chart 3: FOMC projections on several key economic indicators

Data: Federal Reserve and Bloomberg

Unemployment as of August 2014, core PCE as of July 2014, real GDP averages for 1Q and 2Q 2014.

After Janet Yellen became Fed chair, an important change was made to the March 2014 FOMC statement. The outlook for the fed funds rate, previously tied to an unemployment rate of 6.5%, was changed to a more qualitative assessment of progress, both realized and expected toward the objectives of maximum employment and 2% inflation. At the March 19 press conference, Yellen also reaffirmed that the FOMC statement represents the policymaking device used to communicate opinions and not the members’ forecasts of fed funds (the infamous dot plots). She also endorsed the view that after the asset-purchase program ends, there will be a “considerable period” before it will be appropriate to hike rates, and guided for higher rates in the fall of 2015. At the Sept. 17 FOMC press conference, she made no changes to how she views the dot plots. She did clarify that “conditional period” is not a “calendar concept,” but conditional to economic performance.

A recent publication from the San Francisco Fed commented on the gap between the Fed’s forecasts and market expectations. It found that both economic forecasters and primary dealers expect a more accommodative policy than the median fed funds forecast. Additionally, the authors derived expectations from financial futures (eurodollars and overnight index swaps or OIS) and noted that the market’s implied path was more closely in line with the 25th percentile of the Fed dot forecast, as opposed to the median.

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Chart 4: Peculiar changes to the yield curve in the last year

This divergence indicates that market participants put much weight on what Yellen is saying, given the weak economic backdrop. One of the key lessons of the 1930s was that hiking too early was a major policy error. At today’s zero bound in rates with limited fiscal policy options and a $4.5 trillion balance sheet, the risks to the normalization path currently are asymmetric: Hike too early and risk another double-dip recession with deflationary implications or keep rates low for longer and fight inflation later if and when it arises, given unprecedented tightening potential.

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Chart 5: A historical view of tightening cycles

The yield curve is also pricing in an interesting picture. As the Fed started talking about normalizing rates, the front end of the curve repriced higher, but the long end rallied.

Chart 4 – Peculiar changes to the yield curve in the last year

Data: Bloomberg

In researching previous hiking cycles since 1983, we found that the median cycle lasted 1.4 years and the fed funds rate was raised 2% per year. However, we take the September 2014 FOMC statement at face value and expect this cycle to be different in terms of magnitude.

Chart 5 – A historical view of tightening cycles

Data: Bloomberg and Kansas City Fed

When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2%. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.

Federal Reserve’s statement, September 2014

If the Fed hikes rates because of the improvement in employment, the new LMCI would be consistent with previous hiking cycles when it moves into positive territory. Based on recent trends and research published by the Kansas City Fed, the crossover is likely to occur in late 2015. Another way to think about timing is to infer what "considerable period" meant during previous cycles.

Then-Fed Chair Alan Greenspan referred to a "considerable period" in August 2003, decided the Fed could be "patient" in January 2004, assumed that policy accommodation could be removed at a "measured" pace in May 2004, and tightened in June 2004. During that episode, “considerable period” meant 10 months. If asset purchases end in October 2014 and “considerable period” is taken out, that implies lift-off in August 2015. However, the Fed could wait for the December meeting, which has a press conference, to remove it. A similar preference for transparency could affect its decisions next year, making the likelihood of the first hike higher at meetings with a press conference. In 2015, there are four meetings with a press conference scheduled: March, June, September, and December.

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Chart 6: An increasingly dovish Fed?

Another aspect related to the FOMC voting landscape interests us. In 2014, the Fed has had three inflation hawks (Richard Fisher, Charles Plosser, and Loretta Mester) and one “dove” (Narayana Kocherlakota). In 2015, it is forecast to have three doves (Charles Evans, John Williams, and Dennis Lockhart) and only one hawk (Jeffrey Lacker). Assuming that the two vacancies remain open, and if we equally weight each vote, the committee would shift from slightly dovish to moderately dovish. If we assume some "pull to leadership" and assign a heavier weight to Yellen, then equally weight all remaining votes, the bias could be even more dovish.

Chart 6 – An increasingly dovish Fed?

Dovish
Hawkish

Source: Societe Generale. Subjective scores based on recent speeches.

Given all this information, our bottom line is that, barring a major surge in economic growth, we expect the Fed to begin a slow and gradual normalization process late in the third quarter of 2015, or possibly even later. However, the timing is less important to us than knowing that this cycle is likely to be different than historical cycles, and that Yellen would rather wait longer than risk hiking too soon, given the weak economic backdrop.


The views expressed represent the Manager's assessment of the market environment as of September 2014, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting delawarefunds.com/literature or calling 800 362-7500. Investors should read the prospectuses and the summary prospectuses carefully before investing.

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