With its quantitative easing program set to end, the Federal Reserve faces a decision Wednesday about whether to communicate that it will raise interest rates earlier than previously signaled.
As Chairwoman Janet Yellen and other members of the Fed’s monetary policy committee meet in Washington Tuesday for a two-day meeting, the big question is how long they will wait to raise short-term interest rates after they reduce the Fed’s purchases of Treasury and mortgage-backed securities to zero in October.
Raising short-term rates from near zero for the first time since the financial crisis would increase the cost of borrowing throughout the economy; for businesses financing investments and for individuals taking out mortgages, opening credit cards or buying cars.
“Really what the markets are looking for is guidance,” said Craig Alexander, chief economist for TD Bank Group. “If quantitative easing is going to end in October, the question immediately becomes: OK, when are you going to get the first tightening?”
In recent meetings, the Fed’s monetary policy committee has said interest rates will remain near zero until a “considerable time” after the bond purchases end. Investors will be watching the committee’s announcement Wednesday afternoon and Yellen’s subsequent press conference to see whether that phrase is dropped and what kind of guidance might replace it.
“It’s a very tough call as to whether or not the Fed drops the ‘considerable time’ reference, it’s really a coin toss,” Alexander said.
Currently, surveys of investors as well as bond market prices place the timing of the first interest rate hike in mid-2015. Moving up that anticipated date by removing the “considerable time” reference would be “a big hawkish shift,” Goldman Sachs chief economist Jan Hatzius wrote in a research note.
In recent weeks, some Fed policymakers have suggested that the language should be changed to allow for the possibility that more good news about economic growth and job gains will necessitate that the central bank tighten the money supply by raising rates earlier. That possibility has seemed more plausible as the unemployment rate has fallen by over a percentage point in the past year to 6.1 percent.
Federal Reserve Bank of Philadelphia President Charles Plosser dissented from the Fed’s July monetary policy decision because the “considerable time” language did not reflect the “considerable economic progress that has been made.”
Plosser recently has been joined by Cleveland Fed President Loretta Mester, who said this month that “my preference is for forward guidance to convey that changes in the stance of policy will be calibrated to the economy’s actual progress and anticipated progress… A faster pace of progress toward our goals would argue for a faster return to normal, while a more subdued pace would argue for a slower return.”
Even Eric Rosengren, the Boston Fed president considered one of the most “dovish” members of the Fed who favors looser money for longer, said this month that “we should be moving away from providing date-based forward guidance, and instead focus on what incoming data tell us.” Rosengren is not among the rotating group of regional Fed presidents with votes on monetary policy this year.
There’s “enough of a move within the [committee] that Yellen is going to be looking for some compromise position” on the language regarding rates, said University of Oregon professor and Fed watcher Tim Duy. In other words, even if the “considerable time” phrasing is removed, Yellen will find a way to reassure markets that the Fed won’t tighten the money supply before the data shows clear evidence of a sustainable recovery.
Previously, Yellen had said there was plenty of “slack” in labor markets, citing statistics such as the large number of people forced into part-time work and the low labor force participation rate. Such slack, Yellen argued, meant that the Fed could add monetary stimulus without fear of generating too-high inflation.
But more recently, at a speech in Jackson Hole, Wyo., in late August, Yellen appeared to acknowledge that the jobs recovery has been stronger than she had anticipated. Interpretations of the strength of the labor market “need to become more nuanced,” she said.
“I do think that, when she says she has a pragmatic view on this topic, that she’s being honest,” said Duy, adding that “she will move as the data shifts.”
