By Kristina Hooper, Steve Malin and Greg Meier
End of 'patient' language
According to the meeting minutes, there was wide agreement on removing the "patient" language at the Federal Open Market Committee's March 2015 discussion. Keep in mind that in its December meeting announcement, the FOMC removed the previous "considerable time" wording and replaced it with the phrase "can be patient in beginning to normalize the stance of monetary policy" - which was similar to language it used in 2004 in advance of raising rates.
At the time the "patience" language was originally added in December, Fed Chair Janet Yellen explained that its removal would signify that the Fed would be ready to raise rates in as few as two meetings later. The March minutes show a consensus that the Fed will not be ready to raise rates in April, but they also show that the Fed is divided on when to start the process of US policy normalization.
- Although the decision to hold rates steady was unanimous, "several" FOMC participants argued that tightening should begin by June 2015, while "others" thought conditions would not be appropriate until "later in the year."
- A "couple of participants" even suggested 2016.
- Both doves and hawks were appeased by the outcome: Not only was the word "patience" removed from the March policy statement in a nod to the hawks, but there were across-the-board downgrades to the Fed's macroeconomic forecasts and monetary policy prescriptions in a nod to the doves.
It is important to stress that removal of "patience" in March clearly leaves the door open for a rate hike in June. While a June rate hike has been on the table for some time - and should not be a surprise - bets on the federal funds futures market suggest investors think otherwise. We remain concerned about the mismatch between market expectations and what the Fed is likely to do, and we expect significant short-term volatility if this occurs.
Policy is still data-dependent and very flexible
The March minutes make it clear that the decision on when to raise rates will remain contingent upon the flow of data. It is clear that the Fed has not yet made up its mind about when liftoff will occur. It is also important to note that the Fed's assessment of the data will be based on both what has been realized and what is expected. The minutes indicate the Fed will take a long-term perspective in implementing monetary policy, which may sometimes seem inconsistent with short-term conditions.
This is consistent with what Fed Chair Yellen said at a recent speech on normalizing monetary policy, when she underscored that the Fed does not want to overshoot its policy goals, making clear that it will move in advance of reaching them: "…policymakers cannot wait until they have achieved their objectives to begin adjusting policy." The FOMC has clearly retained maximum possible flexibility regarding the timing, pace and magnitude of eventual policy rate increases.
Path to normalization may be gradual
The minutes indicate that the data-dependent nature of the Fed's rate-hike decision applies not just to when liftoff will occur, but also to the path of rates. Some meeting participants expect a very gradual path to normalization, and believe that the data dependency of the rate path means there may not be target increases at every meeting.
US economy slows, but some causes are transitory
The FOMC noted that US economic growth has slowed since its January meeting and recognized some weaknesses: a slow housing recovery, weak export growth and a decline in inflation. However, it also noted that some of the causes of this slowdown are transitory in nature. In terms of US jobs, FOMC participants noted continued improvement in the labor market, and that labor-market slack, while still present, continues to diminish.
Inflation moves lower, as expected
Meeting participants recognized that inflation has moved lower but were quick to note that they expected it. A number of participants seemed to be very flexible about the Fed's inflation target, recognizing that there is "no simple criteria for such a judgment." It was noted that with "progress toward maximum employment and reasonable confidence that inflation will move back to 2% over the medium term," the Fed can begin liftoff without seeing increases in core price inflation or wage inflation. We believe this is critical, as it suggests a very easy standard to meet in order for the Fed to begin hiking rates.
Divergent central-bank policies are having a major impact on currency market
Another factor discussed at the March FOMC meeting was the impact divergent central-bank policies will have on the currency market. While the Fed is moving toward tightening, the European Central Bank and the Bank of Japan are significantly increasing monetary accommodation. As a result, the trade-weighted value of the US dollar appreciated at the fastest pace in 40 years during the first quarter of 2015 - not including the spike in the dollar during the financial crisis in the fourth quarter of 2008.
The minutes indicate that several participants "noted that the dollar's further appreciation…was likely to restrain US net exports and economic growth for a time." This is already happening, with the export contribution to gross domestic product growth down sharply during the fourth quarter of 2014. It is important to note that large US companies are more exposed to foreign markets than the overall US economy. This is a key reason why forecasts for S&P 500 earnings have come down so significantly recently.
Key takeaways about the Fed's toolset
The FOMC also delved into the tools the Fed will use to normalize monetary policy. There were a few important takeaways:
- Policymakers confirmed a shift to a 25-basis-point federal funds target range, rather than a specific target rate. This means that liftoff from the current 0.00% - 0.25% range could mean a new 0.25% - 0.50% range. Prior to 2008, the Fed targeted a specific rate.
- The minutes show that policymakers are still testing the tools they will use to raise short-term interest rates when the time becomes appropriate. This is important because of the challenges associated with soaking up the liquidity (i.e., excess reserves) created via the Fed's massive balance-sheet expansion (i.e., quantitative easing). Under certain conditions, short-term rates could fall when the Fed is trying to raise them. One of the tools policymakers intend to use to raise short-term rates during the early stages of monetary tightening-the overnight reverse repurchase agreement (ON RRP) program-has been in testing mode for more than a year and suggests that there could be some undesirable moves in ON RRP rates under certain circumstances.
- For the first time, Fed officials discussed the idea of selling very short-term Treasury securities from the Fed's balance sheet to reduce usage of ON RRPs. However, a number of meeting participants noted that "it could be difficult to communicate the reason for such sales to the public," and it could create a strongly negative market reaction, as "the public could view the sales as a signal of a tighter overall stance of monetary policy than they had anticipated," or as an indication that "the Committee might be more willing than had been thought to sell longer-term assets." In addition, some meeting participants articulated the importance of creating specific plans for policy normalization under a variety of post-liftoff scenarios.
The Bottom Line
We maintain our expectation that the Fed will begin tightening in mid-2015, although we firmly believe it has not yet made up its mind on when it will do so. We continue to stress that the path of rate tightening is far more important than the start of rate tightening.