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Markets Trump the Fed's Forecast


Markets Trump the Fed's Forecast

February 3, 2015

For an institution that prides itself on clear communication - an institution that elevated "forward guidance" to a policy tool - the Federal Reserve seems to be having trouble getting its message across. Either that, or the central bank's words are falling on deaf ears.  

Even as economists parse the Fed statement and conclude that policy makers are getting closer to lift-off from a six-year period of near-zero interest rates, fed funds futures have been moving in the opposite direction, pushing expectations for rate increases farther out into the future. 

Not that those markets ever fully embraced the idea of a June 2015 increase in the federal funds rate, as telegraphed by the bank. Recently the odds of a June move slipped virtually to nil. At 99.84, an implied yield of 0.16 percent, the June contract is close to the average effective funds rate for January of 0.11 percent. (Expiring contracts are settled for cash against the average daily effective funds rate for the delivery month.) The December 2015 contract at 99.58 is placing the probability of a funds rate increase to 50 basis points or higher at 68 percent, according to the CME Group FedWatch tool.

Private forecasters remain upbeat about prospects for 3 percent growth in the U.S. this year. The market isn't listening to them either. To what can we attribute the disparity in outlook? What happened to that old adage, don't fight the Fed?

"Disagreement between economists and the markets over the future of Fed policy in the post-crisis period is nothing new," says Jim Bianco, president of Bianco Research. "In every case since 2009, the markets have proven to be correct."

I suspect they will this time, too. Given the uncertainty (a euphemism for inaccuracy) of its economic forecasts, the Fed relies on the past more than it likes to admit. And the fourth quarter GDP report came with a caveat emptor. While the economy expanded at a real 2.6 percent rate, driven by strong consumer spending and a jump in business inventories, prices as measured by the GDP price index declined for only the fourth time in 60 years. (With rounding, the change came to zero.) Two of the four occurrences were in 2009. 

Consumer prices are falling in the Eurozone. The U.S. CPI is expected to show a year-over-year decline in coming months, depressed by the price of oil and other commodities. The core CPI is slowing as well. The index rose 1.1 percent in the six months ended December compared with 2.2 percent in the first half of 2014. Market-based inflation expectations are plummeting, which has prompted the Fed to emphasize the more stable survey-based measures. 

Central banks outside the U.S. are leaning in the opposite direction of the Fed. The Bank of Canada surprised markets with a quarter-point rate cut two weeks ago, citing the downside risks to inflation and financial stability from lower oil prices. Also in a surprise move, the Swiss National Bank abandoned the cap on its currency and lowered its target rate to -0.75 percent. The central banks of Singapore, India and Denmark eased policy unexpectedly last month while the European Central Bank embarked on a well-anticipated, open-ended program of quantitative easing. The Reserve Bank of New Zealand retreated from its outlook for higher rates. And Australia jumped on the rate-cutting bandwagon on Tuesday.

Taken together, these actions suggest that global disinflation has overwhelmed any discussion of raising interest rates. The Fed acknowledged as much by adding "international developments" to its watch list in its Jan. 28 statement.

As for its ability to communicate clearly, the Fed seems to be relying on qualitative words and phrases, the meaning of which has to be inferred. For example, policy makers devoted a good deal of attention to the introduction of "patient" in their December statement, according to the meeting minutes. Most committee members thought such language "would provide more flexibility to adjust policy in response to incoming information." (In other words, it means nothing.) Some thought the implication was no change "for at least the next couple of meetings." Some participants thought the language risked "an unwarranted concentration of market expectations" for lift-off around mid-2015, leaving little room for an earlier or later move.

If policy makers can't agree internally on what patient means, it would appear to be an ineffective way to communicate intent.

Fed officials do provide their projections for the funds rates four times a year, in conjunction with the chairman's press conference.  Curiously, policy makers have been extending their target for lift-off. In December, the "dot-plot," or summation of each member's best-guess on the funds rate for the next few years, showed a mean estimate of 1.125 percent for the 2015 year-end funds rate, 2.5 percent for 2016 and 3.5 percent for 2017. In September, the averages were 1.375 percent, 2.875 percent and 3.8 percent, respectively.

Fed chairman Janet Yellen has cautioned against giving too much weight to the dot-plot as a means of telegraphing policy intentions. Better to rely on the statement and press conference.  Which begs the question, why bother? Like all forecasts, these are subject to change. Still, it seems noteworthy that the committee is downgrading its expectations for normalizing rates even as the language is designed to prepare the market for lift-off.

No wonder the markets aren’t listening.  


Caroline Baum is a contributor to e21. You can follow her on Twitter here.

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