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Fed changes criteria for raising rates

By Sheyna Steiner · Bankrate.com
Wednesday, March 19, 2014
Posted: 2 pm ET

Interest rates will stay very low for the foreseeable future, the rate-setting committee at the Federal Reserve announced today, following a two-day meeting.

The only surprise in this week's statement appeared in the "forward guidance," in which the central bank tried once again to clarify the timing of a future interest rate increase. This time around, the central bank described the essence of what it will look for in the potpourri of economic indicators before it raises rates. It removed the unemployment threshold.

Essence of the change

Previous statements used unemployment and inflation thresholds to explain the potential timing of interest rate changes. This week's statement acknowledged the quickly approaching 6.5 percent unemployment threshold (set at previous meetings) but noted that the update to the forward guidance "does not indicate any change in the Committee's policy intentions as set forth in its recent statements."

The Fed summarized its updated policy by saying it "will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent." Gone is the Fed's former benchmark of an unemployment rate below 6.5 percent. The committee said it might keep a key interest rate near zero percent "even after employment and inflation are near mandate-consistent levels."

New leader of the Fed

The meeting is noteworthy as it marks the first Federal Open Market Committee, or FOMC, meeting chaired by Janet Yellen, the new chairman of the Federal Reserve and the first woman to hold that post. Despite the change in leadership, it's business as usual at the central bank.

"She has pretty much made it clear that she will be Bernanke in female form," says Michael Gayed, CFA, co-portfolio manager of the ATAC Inflation Rotation Fund, or ATACX.

Shrinking bond purchases

Aside from the change to forward guidance, the monetary policy statement sticks to the script set by Yellen's predecessor, Ben Bernanke. For the third meeting in a row, the central bank reined in the asset purchase program known as quantitative easing by $10 billion.

Before the central bank began scaling down bond purchases in December, monthly acquisitions of mortgage-backed securities, or MBS, and Treasury securities totaled $85 billion. After today's announcement just $55 billion worth of bonds will be purchased monthly, beginning in April. That means $25 billion worth of mortgage backed securities and $30 billion longer-term Treasury securities will be added to the Fed's bulging balance sheet.

But still, a bunch of bonds

And it is bulging: According to the annual financial statement released by the central bank last week, the central bank's assets total $4 trillion. In 2013, holdings of U.S. Treasury securities increased by $550.2 billion, and federal agency and government-sponsored enterprise MBS holdings increased by $583.5 billion.

Before the financial crisis, the assets of the Federal Reserve were between $800 and $900 billion, the Wall Street Journal reported in March.

A low federal funds rate

Since Dec. 2008, the federal funds rate has targeted between 0 and 25 basis points. The average daily effective federal funds rate in March has been 0.08 percent, according to the Federal Reserve Bank of New York.

Guiding market expectations

Forward guidance gives market participants a sense of the economic conditions that the FOMC will look for before raising the federal funds rate. At the same time, the guidance gives the Fed leeway, so it's not beholden to anything too specific.

By removing the reference to the unemployment rate, the Fed can describe the qualities of its ideal economic scenarios without risking the confusion of including specific numbers that seem increasingly less relevant as the economy recovers.

"They had been focusing on a 6.5 percent unemployment threshold. And have had to massage that as the unemployment rate had fallen faster than expected without the associated inflation pressures that they thought they would see," says Alan Levenson, chief economist at T. Rowe Price Associates.

"Now with the unemployment rate fast approaching 6.5 percent, they want to emphasize that threshold less and start talking about the other conditions that will prevail," he says.
Most notably inflation, which has failed to rise as the unemployment rate fell.

Communications versus expectations

Clearly communicating intentions without raising expectations is a tricky goal. "This has been a bit of a problem for the Fed," Gayed says.

"They have, seemingly at almost every other meeting, changed their wording for forward guidance," he says. Previously, the forward guidance announced that, in addition to a host of other metrics, the central bank would look for an unemployment rate of 6.5 percent and an inflation rate of 2 percent.

The economy is a slippery pig

Though inflation measures at a benign level now, price increases could be around the corner. Gauging exactly how much slack is in the economy is more of an art than a science.

Slack in the economy refers to the "capacity to pick up the pace of growth without causing inflation," says Peter Lazaroff, CFA, portfolio manager for Acropolis Investment Management in St. Louis.

One way economists measure slack is by looking at the labor market and wage growth.

As the unemployment rate falls and the number of job openings begins to outstrip the number of unemployed people looking for work "there is more competition for qualified workers. Employers try to draw people back into the labor market with increased wages. That wage inflation passes through to price inflation. That is the general dynamic," Levenson says.

Dolla, dolla bills y'all

Wages have been going up recently. In February, average hourly earnings for production and nonsupervisory workers, over three-quarters of all employees, were up 2.5 percent year-over-year, according to the Labor Department.

"The rate of wage inflation got as low as 1 or 1.5 percent," says Levenson. "If you're in the camp that believes that most of those who have exited the labor force are not going to reenter and there will not be a big rebound in labor force participation as economy improves, we'll see more of this wage inflation trend -- if there is not as much slack in the labor market as the Fed thinks," he says.

The Federal Reserve could very well be reading the tea leaves correctly. The unemployment rate rose in February as discouraged workers returned to the workforce to look for jobs. A continuation of that trend could keep inflation at bay. That will give the central bank plenty of time to see how their accommodative policies play out as QE ends.

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