01.04.2007
Rate Hiking Versus Policy Firming
Did yesterday’s release of the minutes of the December meeting of the Federal Open Market Committee change anyone’s assessment of where the federal funds rate is headed? Our own estimates of market expectations (estimated from options on federal funds futures) say no, but the reaction in the broader markets – or at least the market-watchers’ interpretations of the reaction – say yes. From The Wall Street Journal Online (subscription required, emphasis in the original)…
The deal remains this: The Fed was still talking about raising interest rates last month because “price pressures were not yet viewed as convincingly on a downward trend.”…
The committee goes on about the “extent and timing” of higher rates to “address these risks,” but they’re still not talking about the possibility of lowering interest rates, which has come as a surprise to the equity market.
… and from the Financial Times:
US stocks surrendered a firm start to the new trading year on Wednesday after the Federal Reserve signalled there was little chance of an interest rate cut until core inflation moderates.
Those sound like very similar statements, and indeed they are. But there is actually a subtle, but important, difference: The Journal snippet refers to “higher rates,” the FT excerpt does not.
If you do a quick search of the most recent FOMC minutes, you will find no reference to higher federal funds rates. What you will find is this (emphasis added):
Members agreed that the statement should continue to convey that inflation risks remained of greatest concern and that additional policy firming was possible.
Is there really a distinction between the phrase “higher rates” and the phrase “policy firming”? I think the answer is “yes,” or at least “there could be.” In this Bank’s 2001 annual report, we described then-president Jerry Jordan’s position on the rate cuts of that year:
[The view that growth in measured monetary aggregates is not a useful guide to policy] make[s] it easy to forget, or to fail to appreciate, two essential facts. First, market interest rates—especially real (inflation-adjusted) rates—have a life of their own, independent of monetary policy. Second, when events conspire to move inflation-adjusted market rates, maintaining a given funds rate requires the Federal Reserve to alter the pace at which it injects liquidity into the economy. The latter observation means that when circumstances in the rest of the economy change, failing to move the funds rate is likely to alter the stance of monetary policy by default.
I want to make it clear that I am not attempting to suggest what any given member of the Committee might mean to convey with the phrase “policy firming.” What I am saying is that there is, in fact, an interpretation in which policy firming need only mean not moving the funds rate target, or even lowering it slowly. In that sense, market reactions driven by the belief that tight policy may be ahead may be fully consistent with the absence of change in the probabilities attached to future federal funds rate changes.