This week’s Fed meeting is important not because the Fed will actually change its monetary policy – it won’t – but because the statement and press conference will be scrutinized intensely for hints about when the Fed will begin hiking interest rates. At the press conference, Fed Chair Janet Yellen will offer her perspective on the timing and pace of normalization. In a speech on 22 May, Yellen said,
“… [I]f the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy. To support taking this step, however, I will need to see continued improvement in labor market conditions, and I will need to be reasonably confident that inflation will move back to 2 percent over the medium term.”
Note that the standard for the labor market is “continued improvement,” and given the strong recent employment data, Yellen will likely confirm Wednesday that this condition is likely to be met “at some point this year.” As for inflation, note the Yellen standard for a hike is not that actual inflation moves back to 2% but only that the Fed be “reasonably confident” that inflation will move back to target in the medium term.
So the big news, if any, on Wednesday will be if and how Yellen refines her language to indicate when “later this year” is likely to happen – September or December? Here she faces a difficult communication challenge. If she gives no guidance other than uttering the phrase “data dependent,” markets may interpret this as a signal that September is unlikely – which would play into the theme given support by IMF Managing Director Christine Lagarde’s recent advice that the Fed should wait until 2016 and Fed Governor Lael Brainard’s recommendation that the Fed should wait and scrutinize incoming data before deciding to hike. The disadvantage to Yellen of this approach is that it would make it harder for the Fed to hike in September even if the data supports that decision.
If, instead, Yellen seems to indicate she will “see us in September” (as The Tempos’ song says) for a rate hike announcement, she has the opposite problem, which is that she will be seen as giving calendar date guidance when she wants the Fed to get away from that.
Right now, markets are pricing a less than 30% probability the Fed hikes in September, but a greater than 60% probability they hike by December (source: Bloomberg, based on fed funds futures prices). PIMCO sees higher odds of a September hike than the markets do, and I suspect Yellen would not be unhappy if, after her press conference on Wednesday, the markets price in a higher probability of a September hike as well.
The key message is that investors need to get ready for, and used to, monetary policy that is data dependent. It is conceptually a better way to conduct monetary policy, but it is also more difficult to communicate strategically. Yellen will be getting lots of practice in the months and years ahead.