While the Fed has been steadfast in saying that any change in policy will be data dependent, we believe this is focused on satisfying checkbox one. The last thing the Fed wants to do is to start hiking interest rates, to then pause or reverse course when the economy starts to sputter. The prospect of a “failure to launch” scenario may be why the market remains more sanguine than the Fed on how and to what level short rates might rise. After nearly seven years of accommodation, this may be the biggest risk the Fed hopes to avoid.
In the case of part two, this was likely what forward rate guidance was designed to accomplish. By having the Fed “clearly” telegraphing its intentions, the hope was that the market would look to these cues and be able to reflect the Fed’s position in financial markets. This could have the effect of reducing market volatility when the Fed shifts policy. Unfortunately, the market is betting that the Fed’s views are too aggressive. In response, should we continue to see an improvement in economic data in coming weeks, we believe the Fed is likely to be more vocal in its discussion of the future path of rates.
While the market has shrugged off this signal initially, we believe stronger economic data can break down this resistance. Additionally, likely changes to statements at the Fed’s next meeting October 29 could reinforce this trend. As we noted in a previous discussion of her first Fed meeting, when the chairman talks, the markets listen. As a result, we believe that interest rates at the short end of the yield curve may be poised to rise in the coming weeks in response to positive economic data. While our thesis may not materialize immediately, we believe now may represent a prudent time to reduce interest rate risk in advance of a future change in policy.
1Source: Press release, Board of Governors of the Federal Reserve System, 9/17/14.
2Jens H.E. Christensen and Simon Kwan, “Assessing Expectations of Monetary Policy,” Federal Reserve Bank of San Francisco, 9/8/14.