Evan Lefkovitz '16
After the 2008 recession, the Federal Reserve Board, in an effort to combat disinflation, instituted a series of quantitative easing measures through the purchase of mortgage-backed and treasury securities. The goal of these quantitative easing measures was to spur inflation to a level conducive to economic progress, at which point interest rates could gradually be increased. Now, the third round of quantitative easing, known as “QE3,” has come to an end. The Fed has repeatedly indicated that it will maintain low interest rates for a “considerable time” after quantitative easing is completed. Federal Reserve Chair Janet Yellen has made it clear that the Fed will not increase interest rates until there is a jump in employment and a 2 percent long-run inflation rate in the same calendar year.
September got off to a promising start when the Labor Department announced a 5.9% U.S. unemployment rate, a number close to the Fed’s estimated goal in the range of 5.2% to 5.5%. However, Wednesday’s release of the minutes from the latest Federal Open Market Committee (FOMC) meeting pointed towards a poor outlook for a sustained 2% running inflation. The minutes shed light upon the Fed’s concern with the strong dollar and economic issues abroad. The Fed is worried that the U.S. dollar has the potential to strengthen in a way that will stagnate inflation. Furthermore, members of the Fed expressed concern with slow growth in both Europe and Asia, claiming that inflation in these areas could potentially hurt the U.S. exports and slow domestic inflation.
The pressing uncertainty at hand is the future direction of the Fed’s policy. Specifically, the phrase “considerable time” is rather ambiguous; nobody is certain as to when the Fed will actually raise interest rates. It was originally expected that the Fed would begin to raise interest rates sometime in mid-2015. However, at the September meeting, the Fed voted 8-2 in favor of keeping short-term interest rates down without providing any tangible guidance for a future increase. The members of the Fed continued to maintain that any rise in the interest rates would be inextricably linked to positive U.S. economic performance. Thus, in the direct aftermath of the minutes’ release, investors interpreted the Fed’s aforementioned concerns with inflation as a justification for a “dovish” attitude. This means that investors concluded that the Fed will wait longer than expected to boost interest rates, and as a result markets jumped. The Dow Jones industrial average went up 1.6 percent to 16,994.
The market’s analysis and reaction to the release of the minutes seems to be justified. John Williams, a Federal Reserve official seen as “closely aligned” with Yellen, confirmed Thursday that while it is expected that interest rates will gradually be increased in mid-2015, it is contingent upon unemployment dropping below the 5.5% threshold and inflation rising to and running at the 2% target. Moreover, according to calculations by Barclays Capital using the consumer price index, U.S. inflation expectations in 5 to 10 years have dropped from 2.91% in June to 2.57% in October. In contrast, European inflation expectations only dropped from 2.13% to 1.90% according to Barclays. Barclays strategist Michael Pond noted “the Fed has responded to falling expectations in the past by producing additional policy measures aimed at spurring growth.” The Fed could employ these statistics as reasonable evidence for “dovish” policy and the maintenance of low interest rates beyond the target date of mid-2015.
It will be interesting to see how the Fed reacts to these issues at the next meeting of the FOMC at the end of October. Some Fed members have called on the Fed to clarify the meaning of “considerable time,” which could potentially result in the identification of a target date for the increase in interest rates. Ultimately, former Fed governor Laurence Meyer hit the nail on the head when he noted that “the timing of the first rate hike is all about inflation.” The evidence strongly suggests that the Fed will not make any formal declarations until it can ensure that its inflation goals will be met. Without this perceived guarantee of economic stability, the Fed will refuse to raise the interest rates.
Sources:
http://www.businessinsider.com/fomc-minutes-october-8-2014-10
http://www.reuters.com/article/2014/10/08/us-usa-fed-idUSKCN0HX20M20141008
http://www.reuters.com/article/2014/10/09/usa-fed-williams-idUSN9N0PZ02820141009