Chandler Bond Market Review

January FOMC Meeting Introduces New Communication Strategy and Communicates Subtle Shift

At the January 24-25 meeting, the Federal Reserve put into practice a new approach to communicating with the public. Introduced at the immediately preceding Federal Open Market Committee (FOMC) meeting held in December, the new strategy features meaningful changes in the way the FOMC publicizes its opinions about the future state of the economy and its intentions about policy actions.

The FOMC has a dual mandate: fostering maximum employment and ensuring price stability. The way the FOMC communicates its policy goals and actions plays an important role in enhancing monetary policy and reduces economic and financial uncertainty. The January changes are the most recent in the FOMC’s evolution to greater transparency in the interest of making financial markets less volatile and more reflective of relevant information for monetary policy.

Specifically, the new approach will provide information in three areas:

  • FOMC members’ projections of the appropriate level of the target federal funds rate in the fourth quarter of 2012, the next few calendar years, and over the “longer run.”

It is worth noting, the FOMC does not forecast the Federal Funds rate since it actually sets the Fed Funds target. The forecasts for inflation, GDP and unemployment are dependent upon the interest rate it sets. Each committee participant is instructed to assume the path consistent with the committee’s longer-run objectives and then provide forecasts of GDP, inflation, and unemployment.

  • FOMC members’ projections of the timing of the first increase in the target rate.
  • A narrative describing factors underlying the assessments and qualitative information about participants’ expectations for the Fed’s balance sheet

The forecasts do not identify participants individually.

While there are benefits to greater transparency and accountability that the enhanced communication fosters, arguments may be made that providing such information might increase market volatility especially during times when forecasting is more challenging than today.

What the Fed Actually Said
Market expectations have been that the Federal Reserve would maintain its target Federal Funds (Fed Funds)1 rate at current low levels through mid 2013. Significantly, the Fed pushed back the date for any likely increase in this interest rate by at least a year and a half, until late 2014 at the earliest. The Fed stated that rates at such levels continue to be needed to help boost an improving but still sluggish economy.

Beyond the adjusted outlook for interest rates, Wednesday’s statement closely tracked the Fed’s previous comments about economic conditions. The Federal Reserve reduced its outlook for economic growth for 2012 but expressed a slightly more optimistic view about the unemployment rate. It expects the economy to grow between 2.2 percent and 2.7 percent this year, a decrease from the November forecast of between 2.5 percent and 2.9 percent. It expects unemployment to fall as low as 8.2 percent this year, an improvement over the earlier forecast of 8.5 percent.

In implementing the new communication strategy, the Fed provided a rate forecast and a forecast of the timing along with the expectations of the 17 individual Fed policymakers.2 The distribution charts clarify the consensus and range of forecasts amongst the participants. Some Fed participants forecast record-low interest rates beyond late 2014 while others see increases sooner. While the consensus is to hold rates low and the Fed stated there will be “exceptionally low rates through at least 2014” reviewing dispersion of the forecasts in the charts suggests that this does not necessarily mean 0.00-0.25%. The Fed could raise rates slightly before the end of 2014 and the rate would still be “exceptionally low.” Individual forecasts of the movement of the Federal Funds rate were revealed, with six participants anticipating interest rate hikes in 2012 or 2013, in contrast to the broader expectation for low rates through 2014.

Market Reaction
Market reaction to the new communication approach was subdued, with some concern about policy error, increased risk of inflation and its consequent effects on fixed income securities. In the future the dispersion of the participants’ Fed Funds rate and timing forecasts may heighten market volatility.

Continuing Operation Twist
The Fed sees the economy growing at a modest pace. It held off on any further bond-buying programs to try to increase growth at this point. During 2011, the Fed implemented a program of buying government bonds and mortgage-backed securities with the goal of driving down long-term rates and easing borrowing costs. In driving down interest rates, the Fed seeks to encourage people and businesses to borrow and spend, bringing down unemployment. While not announcing further bond buying, the Fed did hold out the possibility of doing so later. It said it was prepared to adjust its “holdings as appropriate to promote a stronger economic recovery in the context of price stability.”

Concluding Thoughts
The recent action to detail the interest rate projections of each of the 17 members who participate in policy meetings, without identifying them by name, advances the Federal Reserve towards more open communication. While market response to the inaugural implementation of this approach was muted, it will be interesting to gauge the market’s response in the future.

Footnotes
1 The Federal Funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually on an overnight basis. Institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances. The federal funds target rate is an administered rate, determined by a meeting of the members of the Federal Open Market Committee.
2 Currently there are 17 participants: Five are Federal Reserve Board Governors and twelve are Federal Reserve Bank Presidents. There are two Federal Reserve Board Governor positions that are unfilled. Only five of the 12 regional Federal Reserve Bank Presidents get to vote at meetings, on a rotating basis, meaning seven people get express their views but not decide.

RISKS AND OTHER IMPORTANT CONSIDERATIONS

This report is provided for general information purposes only and should not be construed as specific legal, tax, or financial planning advice. All opinions and views constitute judgments or relevant information as of the date of writing and such information may become outdated or superseded at any time without notice. This report is not intended to constitute an offer, solicitation, recommendation or advice regarding any securities or investment strategy. This information should not be regarded by recipients as a substitute for the exercise of their own judgment. Fixed income investments are subject to interest, credit, and market risk. Interest rate risk: the value of fixed income investments will decline as interest rates rise. Credit risk: the possibility that the borrower may not be able to repay interest and principal. Low rated bonds generally have to pay higher interest rates to attract investors willing to take on greater risk. Market risk: the bond market in general could decline due to economic conditions,especially during periods of rising interest rates.

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