From JPM's Michael Feroli
Tapering vs tightening is only the beginning
Chairman Bernanke's remarks in Boston were dovish on the outlook for interest rates, but did little to counter the notion that tapering will occur relatively soon. In some ways his comments echoed those from earlier in summer and spring: distinguishing the asset purchase policy from the zero rate policy, and emphasizing that decisions on one policy won't necessarily impact decisions for the other policy. However, yesterday his remarks went further, by laying out the reasons for why rates won't rise dramatically in the medium-term. The reason for this subtle change in emphasis is the revised forecasts released after the most recent FOMC meeting, which showed a quicker move down in the unemployment rate. Irrespective of tapering concerns, this change in forecasts makes it harder for the Chairman to argue that rates will be low for a very long time. The approach he took yesterday mirrored some recent Fed research in arguing that the unemployment rate understates the degree of labor market slack. Ultimately, however, the emerging communications challenge was apparent to the FOMC even last year as they debated the threshold guidance: only laying out conditions for the first rate hike is an incomplete means to ensuring accommodative financial conditions, as the market may thereafter price an aggressive path of tightening. In any event, unlike tapering, tightening will likely be a choice for Bernanke's successor, so what he says about the conditions for tightening are only indicative of the thinking that may prevail at that time.
Nothing in yesterday's remarks led us to question our view that tapering in September is coming, conditional on the data cooperating. To the contrary, when asked if he regretted mentioning slowing the pace of purchases recently, he stated that "notwithstanding some volatility that we've seen in the past six weeks, that speaking now and explaining what we're doing may have avoided, you know, a much more difficult situation in another time." Rather than push back against the way his comments were interpreted, the Chairman seemed to welcome the better alignment of the market's view with the Fed's view.
Where things get more interesting is with respect to interest rate policy. Here, as usual, the Chairman distinguished the goals of asset purchase policy -- to get "some near-term momentum" -- from those of interest rate policy, to see the recovery through at least to the point at which the economic thresholds are achieved. Given the tame outlook for inflation, the more relevant threshold is the 6.5% unemployment rate. The most recent FOMC forecasts indicate they expect that to be reached around the end of next year or early 2015. In principle, a change in FOMC forecasts shouldn't alter the market's pricing of the Fed, as Fed growth forecasts haven't been shown to significantly outperform private sector forecasts. The repricing of Fed rate hike expectations suggests that in practice the market believes the Fed is a better forecaster, or else really thinks the Fed reaction function has changed.
Perhaps in part to address this second concern, the Chairman yesterday tried to modulate post-lift-off rate hike expectations. On two occasions he made reference to the inadequacy of the unemployment rate, as it either "overstates the health of our labor market" or "understates the weakness of the labor market." This should be considered in the context of traditional macro models which, in normal times, suggest that the unemployment rate would be near the natural rate, or NAIRU, and the funds rate would be near its neutral rate. The most recent FOMC projections point to a NAIRU of 5.6% and a neutral funds rate of 4.0%. That means, again in the context of traditional macro models, that after the 6.5% threshold is hit, the Fed will need to hike 400bps (or 375bps depending on how you count), for the next 100bp decline in the unemployment rate. One interpretation of Bernanke's comments yesterday is a slight move away from these traditional macro models. In particular, a recent research paper by two senior economists affiliated with the Fed, Chris Erceg and Andy Levin, recommends that in the presence of a depressed labor force participation rate, the funds rate should be kept below neutral even as the unemployment rate gets back toward its natural rate.