20 maart 2014

Dots, dots, dots: forward guidance of FED

Dots, dots, dots, that will be the story for the bond market in the coming quarters. What are the dots, may I have your dot please will be asked to every FED governor. Reading the FED tea leaves will be dottology.

The FED has a problem with its forward guidance. It has to become less quantitative because the unemloyment rate will fall below 6.5% at a moment there is still considerable slack in the economy, the participation rate too low and inflation, especially PCE.

Still the market wants hard numbers. The only hard numbers left after a change to a qualitative guidance why interest rates must remain below what the Taylor rule is saying for a considerable period are the dots of the individual forecasts of the FED governors for the FED rates in the future.

At the moment the market prices the forward rates about what the dots are saying, even a bit lower. That is based on the expectation that the dot of Janet Yellen is more dovish than the average and that she will get her dot more important with the help of Stanley Fischer. 

Because of the soft patch the dots of FED went further out in the future for the first hike. The governors were more afraid again that their growth expectations were too high.

Now economic growth is returning the reverse should happen. The first hike will come more nearby in the coming year.

Hilsenrath (http://blogs.wsj.com/economics/2014/03/17/grand-central-the-persistence-of-persistent-headwinds-in-the-economy/) indicated that the forward guidance will be defended like Bernanke did: he was saying in September that the economic growth faced more headwinds than normal and so monetary policy has to be much more easy than the Taylor rule will indicate. The FED will probably copy what Carney will say about forward guidance.

[Mark Carney, governor of the Bank of England, said in a press conference last month that “persistent headwinds mean that, even in the medium term, the level of interest rates necessary to sustain low unemployment and price stability will be materially lower than before the crisis.” Ben Bernanke, the former Federal Reserve chairman, said in a press conference last September, “we expect that a number of factors—including the slow recovery of the housing sector, continued fiscal drag, perhaps continued effects from the financial crisis—may still prove to be headwinds to the recovery.” Here’s why this matters so much. The central banks are projecting an economy that looks on its face like it is returning to normal in the next couple of years. The Fed, for instance, projects that by the end of 2016 the unemployment rate will be near long-run average between 5.2% and 5.8% and inflation will be near the Fed’s long-run target of 2%. Yet most Fed officials are projecting the target for short-term interest rates will be below 2%, much less than the 4% level that officials think is appropriate in normal times.]

 This story will believed less when economic growth recovers and especially when inflation goes up. A little bit higher inflation expectations (e.g. because of higher food prices) will have big consequences for the yield curve. It will increase substantially the belief that the FED is behind the curve as the Taylor rule says.

So for the short run the headwinds story of forward guidance will be believed, but already now monetarists are writing that you have to watch inflation and credit growth and not use the headwinds story. The hawks will become louder, QE has to go and the FED must be not too obvious behind the curve.

N.B. Yellen indicated like Bernanke that the dots are not important, just believe the FED statement. The buck stops with me.

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