Fed Funds Rate to Remain Low At Least Through 2014

As expected the FOMC announced it is keeping its target rate unchanged but now see that economic conditions are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014. There were no other hints at new initiatives. As expected, there were no hints of QE3. However, the Fed has decided to be clear about the inflation part of its dual mandate by stating in a second press release that 2% inflation is most consistent over the long run with its statutory mandate.

With the Fed extending the timeline over which the fed funds rate is expected to remain unchanged at zero to end of 2014, a downgrade in its growth forecasts was likely. And this is exactly what we got. The central tendency forecast by the Fed (Q4/Q4) is now 2.2-2.7% in 2012 (versus 2.5-2.9% previously). The estimate for 2013 is 2.8-3.2% (versus 3.0- 3.5% previously). Interestingly, despite the lower growth forecasts, the projection for the unemployment rate was revised lower: 8.2-8.5% for 2012 (versus 8.5-8.7% previously) and to 7.4-8.1% for 2013 (7.8-8.2% previously). The downward changes to the inflation projections (both PCE and core) were very minor. For the first time, the FOMC presented information about how participants feel about the pace of policy firming going forward (although there's no information about voting and non-voting members' views). Three of the 17 participants thought that rate hikes were appropriate this year and three more saw higher rates as appropriate in 2013. Eleven of seventeen viewed rate hikes as appropriate by 2014. Yet, of those eleven, five saw rates at or lower than 1.0% by year end 2014 and six participants thought rates should still be unchanged by that time. This explains the extension of the low rate projection at least through late 2014. FOMC members view that the fed funds rate should be in the 4-4.5% range over the longer run.

Bottom line:

While the growth downgrades aren’t particularly reassuring, markets are loving the Fed’s promise of low rates for longer. Last year the dissenter was Charles Evans who wanted more stimulus (but who doesn’t vote this year), but this year the dissenter is the incoming member Jeffrey Lacker who tended to be more hawkish in his prior stints at the FOMC. Lacker is already showing his hawkish colours, dissenting against the decision to specify a time period over which federal funds rate will remain exceptionally low.

The bond market rally after the initial statement somewhat moderated after the forecast details were made available. Details of FOMC participants’ views about the appropriate monetary policy stance over the projection horizon highlighted division among the Fed, leaving the bond market somewhat less certain about the future than what was initially interpreted from the press release announcing the rate decision. In mid February, when the minutes will be published, we will get more insight about how FOMC participants see the evolution of the Fed’s balance sheet going forward.