Expect more talk but little rate action from the Fed

If the Fed has its way the taper will continue when it next meets in March, but expect forward guidance to be adjusted as the unemployment rate heads quickly towards its 6.5 per cent threshold.

The minutes from the Federal Reserve meeting in January reveal unanimous support for the decision to continue the taper of its asset purchasing program. At the meeting, the Fed decided to reduce its asset purchases to US$65 billion per month (down from US$75 billion).

Consistent with comments made last week by new Fed chair Janet Yellen (Mellow Yellen stays the course, February 12), the Fed minutes reveal a strong preference “in favour of continuing to reduce the pace of purchases by a total of $10 billion at each FOMC meeting”.

But as always this is based on the assumption that US economic data does not deteriorate or deviate significantly from Fed expectations. Recent data coming from the US has been fairly soft, which for now is being attributed to unseasonably poor weather.

Job creation slowed significantly in December and also January, rising at a much slower pace than during 2013. The housing market has also subsequently weakened. Further weak data prior to the Fed meeting on 18 – 19 March could give it reason for pause, but most data over the next month will continue to be tainted by poor weather.

The minutes suggest that the Fed will soon change its forward guidance to address the fact that the unemployment rate is expected to hit its threshold of 6.5 per cent, after which they would consider raising the federal funds rate. Once the threshold is passed the forward guidance no longer provides any guidance at all.

The unemployment rate threshold has proved problematic because it has fallen at a much faster pace than the Fed had anticipated. It was designed to provide stability to markets and reassure them that rates would not change for a long period of time. Instead the participation rate continued to decline, putting downward pressure on the unemployment rate and pushing it towards its threshold well before most Fed participants were willing to consider raising rates.

The minutes reveal little about what format this new forward guidance would take with a range of views expressed. Some participants prefer providing guidance of a similar nature to that already provided; other participants though a more qualitative approach might be preferable which outlines the factors that would guide the Fed’s policy decisions. For consistency, they will likely continue along a similar track to what they are already doing.

While some participants want to change the bank’s forward guidance, others were looking to increase the cash rate fairly soon. A couple noted that some standard policy rules suggested that the Fed should raise rates before the middle of the year. But other participants, rightly in my view, suggested that standard policy rules remained inappropriate in the current circumstances.

The main reason that increasing the cash rate is not necessary at the moment is because inflation remains at a low level, which indicates that the real interest rate necessary to reach full employment remains below the current real interest rate. Until inflation gathers some momentum there will be little need to increase rates.

Participants looking to raise the cash rate are presumably putting a lot of weight on measures of inflation expectations but there should be some evidence that these expectations are likely to be realised before the cash rate is raised.

Finally, the Fed believes that recent financial market volatility in emerging economies had not been large enough to affect the overall outlook for those economies. In addition, the spillover effects for the United States were likely to be modest at best.

Statements from the Fed in recent months and by their new chair Janet Yellen indicate that the Fed is determined to continue tapering as long as data doesn’t become too soft. Adverse weather conditions make it easy for the Fed to overlook any weakness in new data. Consequently, the Fed is set to lower its asset purchases by a further US$10 billion when it meets on 18 – 19 March.