Yellen to the Markets: Come To Me

By most accounts, the Federal Open Market Committee (FOMC) statement released September 17 failed to break much new ground in terms of changes to policy or language. The Federal Reserve (Fed) met expectations with another measured step in its tapering process, by trimming $5 billion of Treasury and $5 billion of mortgage-backed securities purchases from its asset purchase program.1 While some analysts were looking for removal of the “considerable time” language from the statement, the Fed chose to tweak more innocuous, less market-moving verbiage.

At this meeting, however, investors did receive an update to growth and inflation projections as well as the Fed “dots,” also referred to as the staff’s Summary of Economic Projections, for the first time since June. In this report, economists noted a modest drift higher in the dots for 2015 and 2016, implying a marginally higher forecast for the Federal Funds Rate. Also, the Fed provided rate forecasts through 2017 for the first time. As we discuss below, we believe that chairman Janet Yellen may be uncomfortable with the current disconnect between Fed projections and market implied rates. Over the next several weeks, we may begin to see an increase in rhetoric to condition market rates higher before a formal change is made to the FOMC statement. In our view, Yellen is waiting for the markets to come to her.

Fed Futures vs. Federal Reserve Estimates (Dots)

For definitions of terms and Indexes in the chart, visit our glossary.

On this view, we are in good company. In a paper released September 8 by the Federal Reserve Bank of San Francisco, researchers compared the market’s estimate of future interest rates with the Fed’s own projections.2 In their analysis, the authors explain the notable disconnect between market implied measures and the Fed’s dots. At current levels, the market appears to expect a more accommodative monetary policy than the Fed’s projections suggest. While the researchers don’t necessarily provide a cause, we believe the Fed will likely need to check two boxes before raising rates:

1) A high degree of confidence that the economy has reached “escape velocity” and will be able to function properly without the Fed accommodation

2) That market expectations about interest rates begin to move in the direction of the Fed’s projections so as not to catch financial markets off guard