The Fed’s outlook and leadership in flux

Zach Pandl, Portfolio Manager and Strategist | August 1, 2013

  • Fed policy outlook looks increasingly fluid, including changes in the consensus on the leading candidate for next Fed Chair.
  • There has been increasing speculation around changes to the so-called “Evans Rule”—the Fed’s commitment to keep short-term interest rates low as long as the unemployment rate remains above 6.5%.
  • For the upcoming FOMC meeting, we think a likely outcome would be emphasis that the QE tapering decision will depend on the incoming data, including news on both growth and inflation.

Many observers blamed a lack of clarity from the Federal Reserve (the Fed) for the sharp increase in interest rates after the initial signals about tapering. As a result, in recent weeks Fed officials have tried to calm nerves by stressing that the decision to slow the pace of quantitative easing (QE)—now expected to begin after the September FOMC meeting—does not signal anything about the outlook for the funds rate or their broader policy goals. Unfortunately for the Fed, the policy outlook looks increasingly fluid again.

Most importantly, we learned this week that former Treasury Secretary and White House economic advisor Larry Summers may be the leading candidate to replace Ben Bernanke when he steps down early next year (first noted by the Washington Post but since reported widely elsewhere). Previously, polls indicated that a broad consensus saw Janet Yellen—currently Vice Chair of the Federal Reserve Board—as Bernanke’s most likely successor.

A Summers nomination is by no means a done deal, and his possible candidacy received meaningful pushback from some groups this week, including a letter from Senate Democrats urging the President to select Yellen. However, the news that he is getting a serious look from the White House has immediate market implications. While Summers has long ties to the Democratic party and his public remarks have frequently focused on social welfare issues, he is arguably a more centrist economist by nature than Yellen. In addition, we learned this week that his views on current monetary policy debates differ meaningfully from the Fed leadership. As reported by the Financial Times, Summers argued to a financial industry conference in April that QE was less effective than many people thought, and that policymakers may need to revise down their views of potential output. The remarks indicate that if Summers were nominated, he might cut a different course for policy than a Yellen Fed.

There was also increasing focus this week on possible changes to the so-called “Evans Rule”—the Fed’s commitment to keep short-term interest rates low as long as the unemployment rate remains above 6.5%. First, a number of analysts have argued that the Fed could (and should) lower the unemployment threshold to 6.0% or below. The idea would be to reinforce the message that “tapering is not tightening” by strengthening the forward guidance at the same time that they pullback on QE. We see this change as possible but unlikely. It makes little sense to change the funds rate guidance when the leadership transition has already cast doubt on the credibility of the rule. Plus, current market pricing is closely aligned with the Fed’s own funds rate forecasts (as of the June FOMC meeting), so it is not clear what would be gained.

Second, the Wall Street Journal’s John Hilsenrath reported that the Fed could announce a low inflation threshold, below which they would not raise interest rates. This idea has been discussed by some market economists and bloggers, but to our knowledge has not previously been advocated directly by Fed officials. This change also looks unlikely, in our view, and in any case would have a limited market impact. For the low inflation threshold to bind, the Fed would need to forecast both low unemployment and low inflation. Because inflation is almost always expected to mean revert—at least over multi-year periods—this is a low probability combination. Why would Fed officials want to tie their hands for outcomes that have limited odds anyway?

For the upcoming FOMC meeting, we think a more likely outcome would be modest tweaks to the statement that stress the QE tapering decision will depend on the incoming data, including news on both growth and inflation. Beyond next week, we think the Fed debate is transitioning from well-worn arguments about the structure of QE and forward guidance, to how the next Fed Chair—whoever it might be—will manage the long monetary exit process.

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