The Federal Reserve Open Market Committee has taken the relative small (and symbolically huge) step of raising the target Fed Funds rate by one-quarter point. But its decision-making process and communications to financial markets both before and after the move have been somewhat puzzling.
First, the Federal Reserve has no obligation in normal times to say anything to the financial markets. These are not normal times, however. The Fed has intervened in the workings of the financial markets in an unprecedented manner. It has chosen – rightly, I think – to adopt a more open communication policy, as a result.
After the stock market sell-off in late August, the FOMC decided to maintain its 0%-0.25% target range for the Fed Funds rate. There were strong voices on both sides of this decision. Some warned that the Fed was in danger of making an historic error if it decided to act. Others argued that the time for ending its zero-bound interest rate policy had long since passed. From my perspective, the 25-basis point move was irrelevant; it was most important that the Federal Reserve end its zero interest rate policy officially so that market participants could begin to prepare for higher interest rates. Still, the FOMC’s decision to hold was almost certainly driven by fears about adding to the recent turmoil in the global financial markets.
After the September FOMC meeting, the recovery in the financial markets combined with continued strong employment data provided a window for ending the 0% Fed Funds rate in December. Yet, the financial markets were still on edge. The S&P 500, which had peaked in early November, fell by 4.6% before rebounding prior to the December FOMC meeting. After another favorable jobs report, the FOMC finally acted to lift the benchmark rate and end its zero-bound policy.
The financial markets had been anticipating a Fed move; but it is unclear whether they were also anticipating a median forecast by Fed officials that the Fed Funds rate would increase by 100 basis points in four steps in 2016 to 1.375% and similarly in 2017 and 2018, which would bring it to just over 3%. The futures market has been forecasting two 25 basis point moves in 2016. Given the still sluggish growth in the U.S. economy and ongoing skittishness outside the U.S., the futures seem to have it right.
It was equally surprising, therefore, that Fed Vice Chairman Stanley Fischer would endorse this view in an interview with Steve Liesman on CNBC last week, saying that those Feds Funds rate forecasts were “in the ballpark.” Of course, Mr. Fischer did not indicate how big the ballpark was, so the forecast implicit in Fed Fund futures could also be in that same ballpark. Even so, his statement effectively carries the weight of an official Fed endorsement (even though it does not come from the Chairman).
Given last week’s market sell-off, it is a reasonable bet that the FOMC would not take the same action today as it did in December. How so, then, can Federal Reserve officials justify a forecast central tendency of a 1.375% Fed Funds rate by the end of this year? Certainly, the Fed knows that its summary of Fed officials’ forecasts is well above market expectations. At the very least, Fed officials should begin to address this discrepancy in speeches so the market can begin to understand their thinking.
January 11, 2016
Stephen P. Percoco
Lark Research, Inc.
P.O. Box 1543
Linden, New Jersey 07036