Since the last FOMC meeting, market participants have grown cautious about the near-term path of monetary policy, sending two year rates higher even as the Fed lowers their expectation of the policy path. Is this entirely justified by the economic data, or is another explanation at work? I suggest that the Evans rule has turned hawkish and will increasingly be a challenge for Federal Reserve policy. In short, the nature of forward guidance is very much a question for 2014.
I believe it was David Andolfatto who first recognized the hawkish nature of the Evans Rule:
As Chairman Bernanke stressed in his press conference, the new policy does not imply that the Fed will necessarily raise its policy rate should the unemployment rate fall below the 6.5% threshold...But surely, if the unemployment rate crosses this threshold, the perceived probability of an imminent rate hike is likely to spike up. Absent the unemployment rate threshold, the market would likely expect the policy rate to instead remain low for a longer period of time. This is the hawkish nature of the Evans rule.
Take this in light of Across the Curve's commentary yesterday:
Several participants with whom I have spoken have expressed concern about the unemployment rate and how much it will drop when those jobless whose benefits expired drop out of the work force. That will be a participation rate event but since the FOMC did not tamper with threshold some are concerned about a big drop in the rate.
As I noted, there was some disappointment that the Fed did not change the thresholds. The Fed wants it both ways - they want the impact of changing the threshold without actually changing the threshold. Hence this sentence appears in the statement:
The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal.
The Fed does want to be bound by rules; they want discretion. That is exactly what this sentence is meant to provide. Why don't they want rules? Because they don't know what the rule should be. Remember Federal Reserve Chairman Ben Bernanke's press conference - he thinks the decline in the labor force participation rate is largely structural and that current wage growth is sufficient to deliver a 2% inflation rate. He doesn't sound like he wants his hands tied by some rule, because he doesn't know where to draw the line. 6.5 percent is easy. Is 5.5 percent?
Indeed, those who want the Fed to have rules should pay attention to San Francisco President John Williams:
That said, I expect that the explicit link between future policy actions and specific numerical thresholds, as in the recent FOMC statements, will not be a regular aspect of forward guidance, at least when the federal funds rate is not constrained by the zero lower bound. This guidance has proven to be a powerful tool in current circumstances, when conventional policy stimulus has been limited by the zero lower bound. But such communication is difficult to get right and comes with the risk of oversimplifying and confusing rather than adding clarity. Therefore, in normal times, a more nuanced approach to policy communication will likely be warranted. I see forward guidance typically being of a more qualitative nature, highlighting the key economic factors that affect future policy actions.
This isn't the description of a rule. "Nuance" is equal to "discretion." Rules? We don't need no stinkin' rules! Rules are just an artifact of the zero bound. Once the economy is off the zero bound, Williams is looking to revert to business as normal - loose, discretionary forward guidance, nothing that locks down policy like the Evans rule.
The Fed is faced with a problem here. There is a high probability of smashing through the 6.5% threshold by midyear, rendering the Evans rule pointless. But what replaces the Evans rule? They do not want to lower the threshold unless they were absolutely positive they would not hike rates before that point. But they are not absolutely positive, so they hesitate. At the same time, they do not want the markets to front-run policy. But without a rule, and with a very clear desire to end their other non-conventional tool, asset purchases, can they control expectations? Once we hit 6.5%, we are in a zone in which the Fed is NOT committed to zero interest rates. We enter a zone where the null hypothesis must be that the Fed is biased towards raising rates simply because they are not willing to commit to a rule that suggests otherwise.
Another way to think about this is now that they set a rule, markets will evaluate policy against that rule. It is not easy to just pretend the rule never existed and slip back into discretionary policy.
In the absence of rules, we are looking at the possibility of a volatile year in bond markets as participants attempt to front-run the Fed, and in response the Fed tries to front-run the markets. This is exactly what happened with quantitative easing. Because it was not rule-based but instead discretionary (whatever definition of "stronger and sustainable" the Fed believes is appropriate at the moment), expectations for future policy, and with it interest rates, shifted throughout the year. Once we pass through 6.5 percent unemployment, we are right back there. Although we all know the Fed has said they expect to hold rates at zero for an extended period, they haven't promised to do so. Without that promise, challenges should be expected. The stronger the data, the bigger the challenge.
Bottom Line: The end of the Evans rule is fast approaching. The Fed does not have a backup plan other than talk. Are there new rules ahead? Or is it all discretion? And could you get a divided Fed to agree to new dovish rules in any event? They don't seem eager to change the thresholds. How much stress will force their hand? Might be tough times for Fed communications ahead.