Thursday, March 27, 2014

Speaking the Inconvenient Interest Rate Truth?

On March 19, 2014, Janet Yellen chaired her first meeting after becoming the Fed chair. Her performance in the press conference that followed was mostly solid. However, to a question on how soon the interest rates might increase after the end of the bond-buying program, she responded thus “something on the order of around six months or that type of thing”. Markets interpreted it as another sign that interest rate increases are looming on the horizon.

What are the main outcomes of the meeting that we should focus? First, it reduced the monthly bond purchases to $55 billion from $65 billion. Second, the Fed has abandoned jobless-rate as the threshold for raising interest rates.  To shape its policy on interest rates the Fed will also look at a broader array of indicators. Among the 10 different labor market indicators are the share of workers who have been unemployed for six months or more, the share of adults who are holding or seeking jobs, the portion of workers who hold part-time jobs but say they would rather have full-time occupations, the quit rate, and so on. Besides the labor market indicators, the Fed will also monitor inflation rate, and financial market developments. Third, Fed officials see inflation slowly increasing from 1% to 2% in the years ahead, the economy growing at nearly 3%, and lower unemployment between 6.1% - 6.3% by year-end. Fourth, the Fed officials are still worried about the troubles such as limited access to credit for households, under-water homes, weakness in the global economy, restrictive U.S tax and spending policies, and the insistent caution exercised by corporations. Finally, the Fed’s official policy statement also said that they expect to keep rates lower than normal even after inflation and employment trend back to their long-term stable values.

It appears that the Fed is walking a careful path. It sees a stronger economy and wants to step-back from its easy money policies. However, a rapid move could undermine a very nascent recovery that it has toiled hard to support. The Fed did all it could to assure investors that interest will not increase soon and those increases will be graduated. Investors interpreted the policy statements as mixed signals on the economy. The Fed said that the officials might have been more positive about the outlook at the beginning of the year. Individual officials project a median for the benchmark fed-funds rate at 1% and 2.25% by the end of 2015 and 2016 whereas the Fed’s projections for those are 0.75% and 1.75%. During normal periods the fed-funds rate is around 4% and official policy statement does not forecast that the fed-funds rate will rise to 4% anytime soon.

The Dow Jones Industrial Average fell by 114.02 points and the ten-year benchmark treasury yields rose to 2.770%. The markets were pretty nervous after the Yellen’s first press conference. The markets do not like confusion in the policy statements, Yellen’s remarks, and individual officials’ statements did only help to induce more confusion among investors. If the Fed is bullish on the economic recovery, isn’t time to jump on the bandwagon? Or, have we missed the caravan already?

This article was summarized from the following sources:

1. “Yellen Debut Rattles Markets”, John Hilsenrath and Victoria McGrane, WSJ, March 20, 2014.
2. “5 Takeaways from the Action”, John Hilsenrath, WSJ, March 20, 2014.
3. “In Debut, Echoes of Bernanke”, Victoria McGrane, WSJ, March 20, 2014.

Dr. Subramanian “Subbu” Rama Iyer is an assistant professor of Finance at UNM Anderson School of Management. Click here to contact Dr. Iyer.

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