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FOMC: A striking shift
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Mike Moran, Economic Research
Daiwa Capital Markets, America
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Grant Lewis, Economic Research
Daiwa Capital Markets Europe Limited
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26 January 2012
Last night’s FOMC meeting saw the Committee not only make a striking shift in its policy plans, indicating that short-term interest rates will be kept “exceptionally low” at least through late 2014, but also saw it announce inflation and unemployment rate targets as well as provide for the first time the interest rate forecasts of the FOMC members. Timing of Fed Tightening Source: Federal Open Market Committee
The interest rate forecasts inevitably grabbed most attention and they certainly provided a fresh insight into the FOMC’s thinking. Of the seventeen FOMC participants (ten of which are voting members), only three expect the first interest rate increase to come this year, with a further three expecting it to be in 2013. Six expect the first increase in 2014, while 4 don’t expect an increase until 2015. Rates therefore look to be on hold for at least another two years. And even by the end of 2014 6 members expect rates to be unchanged while 11 of the 17 expect the fed funds rate to be 1% or less.
Pace of Fed Tightening*
* Each dot in a particular year represents the expected federal funds rate of a Fed official. Each year contains 17 dots, 12 for reserve bank presidents and five for Fed governors. Normally, 19 officials participate in the meetings, but two governorships are currently vacant. Source: Federal Open Market Committee
The level of the federal funds rate expected in the longer run (i.e. when the economy is operating normally and policy is in a neutral position) offered no surprises. Most economists believe that neutral monetary policy involves a real federal funds rate of approximately 2%. Given that the Fed announced last night an explicit inflation target of 2%, the fact that almost all FOMC members expect nominal interest rates to be in the range of 4-5% over the longer run is entirely consistent with this. The question, of course, is when the fed funds rate will rise to this level – on the basis of last night’s information, we are a long way off from that.
The adoption of an explicit, inflation target by the FOMC marks a victory for Bernanke, who has long advocated such a move. Of course, FOMC members have long had an implicit inflation target in mind, with most commentators believing that it was somewhere in the region of 1.5-2%. The Committee has now made that explicit, announcing that it will target 2% for the personal consumption deflator. The Fed also set an objective for the unemployment rate, 5.2-6%. But this target will vary over time, reflecting changes in various structural factors in the economy (demographics, skill levels, technological changes, etc.). During his press conference, Bernanke indicated that the Fed is pursuing both objectives and gives equal weight to each. But times will inevitably arise when one might receive more weight than the other.
The statement had little to say about quantitative easing, but the subject came up frequently in the press conference. The Chairman indicated that officials are willing to expand the Fed’s balance sheet if progress in reducing unemployment is slow or if inflation begins to decelerate. However, he also emphasized that it is premature to take a definitive view on prospects for additional QE. The Fed’s current forecast for inflation in 2012 and 2013 is below the 2.0 percent target (see table), raising the possibility of additional QE. The unemployment rate is expected to fall this year and next, perhaps dampening prospects for additional asset purchases. But with unemployment in 2014 expected to remain above the FOMC’s target, further QE cannot be ruled out and while we currently are not expecting another round of quantitative easing, we will keep an open mind.
Economic Projections of Federal Reserve Officials* 
* Forecasts presented at the January 25, 2012 FOMC meeting. Source: Federal Open Market Committee
Mike Moran, Chief Economist, US
Grant Lewis, Head of Research, London
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