June FOMC analysis – a flatter projected rate path

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The statement published after the Federal Open Market Committee (FOMC) meeting on 17 June 2015 was largely in line with our expectations as it reflected the recent improvement in economic activity after a disappointing first quarter in 2015. Somewhat more surprising was the shift down in the projected path of policy rates as revealed in the “dot plot” of the Summary of Economic Projections (SEP).

The median year-end projection for 2015 did not change from the prior projection round, but the constellation of projections imply that seven of the seventeen FOMC participants now see no more than one interest rate increase as appropriate by year-end, up from three during the March projection round.

I take the fifth dot as a rough proxy for the thinking of the three core FOMC members, thus the shift down in the end-2015 dots implies that the Committee leadership is now less confident that a September rate increase will be appropriate. As the Chair said during her press conference, the Committee awaits “more decisive evidence” that the recent pickup in growth will be sustained.

This more cautious approach to the timing of lift-off seems reasonable in light of the fact that participants have marked down their 2015 growth forecasts since March; the mid-point of the central tendency for 2015 growth is now 1.9 percent, compared to 2.5 percent in the March SEP.  A little harder to reconcile with the economic projections, however, is the decline in the median 2016 and 2017 policy projections by 25 basis points each.

This is a bit of a head-scratcher because the GDP, unemployment rate and inflation projections for these years barely budged. One mechanical interpretation is that the downward shift in the median path of rates simply reflects the growing preference for a later start of policy normalization and expectations that the rate path thereafter will be as gradual as the one projected in March.

A more nuanced interpretation is that lingering effects of the crisis will require a risk management approach to tightening for a few more years. That is, the Committee will continue to take a very cautious approach to policy tightening to ensure the recovery stays on track. I am hesitant to view this as a shift in the Committee’s reaction function, as ultimately a 25 basis point change in projected policy rates 18 and 30 months forward is negligible relative to the uncertainty around economic projections at these horizons.

Two interesting points emerged from the press conference, though the first is perhaps not that surprising. Chair Yellen implied that the Committee was unlikely to use a buzzword in its policy statements to describe the path of interest rates once tightening commences, as it did with the “measured pace” language in the prior tightening cycle.

Still, she acknowledged that the final sentence of the current policy statement serves much the same purpose. This confirms a point we have made previously, namely that even as the Committee stresses a more data-dependent approach, it will be difficult for them to move completely away from forms of forward guidance that are intended to reduce market uncertainty about the policy outlook.

The second point of interest during the press conference concerned the use of reverse repo operations (RRPs) during policy normalization. The Chair noted that while RRP usage will be high immediately following liftoff, thereafter the level will be brought down “fairly quickly”.

I am skeptical that the Committee will be able to accomplish this absent another tool to maintain control over short-term rates in an environment of significant excess reserves. The only serious alternative to using large-scale RRPs to reduce reserves would be sales of short-term Treasuries, but this is highly unlikely given the negative impact that sales would have on market volatility at the short end of the Treasury curve.

Steven Friedman

Senior Investment Strategist

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