Fed drops quantitative guidance returns to fuzzy language

Markets usually react to novelty and the single new development in yesterday’s FOMC statement was the forecast for earlier than anticipated rate hikes in the Fed projections. The hawkish projections are a challenge to the Bernanke-Yellen notion that tapering does not imply tightening, especially as bond yields showed their biggest daily rise in 4 months and gold fell by the most in 3 months.

The positive reaction in the USD and bond yields to the FOMC announcement centered around the projections of the FOMC participants, which showed five members expecting 1.0% fed funds rates by end of 2015, which is three more than those projecting a similar outcome in the December meeting. The projections also meant that median projected fed funds rate for the end of 2015 has moved up to 1.0% from 0.75% in the December meeting.

These seemingly hawkish forecasts offset the Fed’s elimination of the 6.5% unemployment forward guidance, which would otherwise have been a broad negative for the US dollar and bond yields had there been no marked increase in the FF projections.

The FOMC issued a more qualitative forward guidance by dropping the 6.5% unemployment threshold, in favour of “…a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.”

The inclusion of the weather factor in the first sentence of the FOMC statement raises the possibility that Q1 weakness was predominantly caused by temporary factors and that a return to more normal conditions will be more appropriately dealt with by tapering of asset purchasing. The weather inclusion is consistent with the FOMC’s higher FF projections but the Fed also added an escape clause by removing the quantitative threshold on unemployment.

Return to fuzzy language means more uncertainty

The Fed’s return to fuzzy language buys it more time in normalizing policy and avoiding any rapid increases in bond yields. As for the period elapsing between the end of the tapering and start of fed hikes, the Fed said “…it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal”.

We’ve been here before

This is neither the first nor last time markets sell-off on new revelation from the Fed. The real challenge will occur after the April taper, when further tightening of US credit markets (rising yields in anticipation of earlier rate hikes) – combines with a slowing China and worries from US earnings ahead of higher rates. Expectations of higher rates are not necessarily bearish as long as post-winter macro-economic momentum extends into Q3. Failure to do so, will force the Fed to highlight the vagueness of its guidance and keep rates low beyond 2015.