- Markets are starting to make understandable inference that Fed officials see a fixed timeline for rate hikes.
- Implied volatility is low because perceived policy uncertainty is low.
- We remain focused on modest slack and sturdy growth.
Recent Fed communication brings to mind Goodhart’s Law: “When a measure becomes a target, it ceases to be a good measure.” In a speech Tuesday, New York Fed President Dudley noted that Eurodollar futures are pricing a liftoff date for the funds rate consistent with the “dots” in the FOMC’s Summary of Economic Projections (SEP). But Goodhart’s logic applies to the Eurodollar curve today: current market pricing is not only consistent with the Fed communication—it’s increasingly perceived to be a target of Fed communication. There’s a growing sense in the market that the committee’s funds rate outlook is not a guess but a guarantee.
Fed officials emphasize that the SEP dots are only a forecast, and that the liftoff date depends on the evolution of economy. Recent speeches have included standard language attempting to stress the data dependence of policy. For instance, President Dudley said:
“Turning first to the timing of lift-off, how the outlook evolves matters … If the economy is stronger than expected, causing the excess slack in the labor market to be absorbed sooner and inflation to rise more quickly than forecasted, then lift-off is likely to be pulled forward in time. If, instead, economic growth disappoints, inflation stays unusually low and the labor market continues to exhibit evidence of considerable excess slack, then lift-off will likely be pushed back in time.”
Why then do markets “misunderstand”, and underestimate the uncertainty around policy? We see three interrelated reasons:
First, it’s hard to infer a monetary policy framework from recent history. For almost five years investors have lived through an environment that looks like the chart below: the unemployment rate has steadily come down but monetary policy keeps getting easier. Stepping back from the storylines that got us here, it’s easy to understand why many investors are skeptical about data dependence. Going with the discretion of policymakers has been the better bet.
Second, many observers have come around to the view that it’s “impossible to measure slack”. We disagree with this idea, but have heard opinions like this in many recent meetings. Again, it is not hard to understand why. In her speech to the New York Economics Club, Fed Chair Yellen said that besides the unemployment rate, the committee will need to consider the share of workers on part-time schedules, the fraction of unemployment which is long-term, the participation rate, and wage growth. But Fed officials neither provide targets for these variables nor give indications about how they will deal with contradictions. Thus the natural thing to do is to simply follow the SEP forecasts, which presumably incorporate all relevant information about slack.
Third, communication does not seem to respond to changes in the unemployment rate—lending support to the calendar-based interpretation of forward guidance. For example, the committee first used the “mid-2015” liftoff date for the funds rate in September 2012 (both in the statement and in the dots). At that time, the SEP forecasts expected the unemployment rate to fall to 6.4% (midpoint of central tendency) by Q4 2015. Today the actual unemployment rate is 6.3%, and yet Fed officials continue to support the same liftoff timeline. More recently, the unemployment rate declined by four tenths over the last month, but there was no discernable change in communication afterward. The data move around but the Fed’s forward guidance does not.
Markets are thus making an understandable inference that Fed officials see a fixed hiking timeline. Maybe the liftoff date has been so sticky because committee members do not want to relitigate the issue if not absolutely necessary. Or maybe the reason is the communication feedback effect described in an outgoing speech by Governor Stein: “the more strongly the market becomes attached to this belief--even if it was initially somewhat arbitrary--the more wary the Committee must be of making an unexpected change, and this wariness further reinforces the market's initial belief”. Thought of in this way, implied volatility is low because policy uncertainty really is low: they’re going to wait until late 2015 come hell or high water.
That at least seems to be the consensus thinking. We are not so sure, and remain focused on the disconnect between modest slack in the economy on the one hand, and the easy stance of policy on the other. Given solid growth and bottoming inflation, we continue to see high risks that Fed officials make a sound this summer that rate hikes will be coming earlier, faster or with more certainty than currently priced.