Forward guidance swings aggressively dovish

| February 1, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Only 25 years ago the Fed began issuing statements after its interest rate moves. Communications have evolved and the FOMC now offers an extensive statement after every meeting describing its view of the current situation, its economic outlook and its monetary policy leanings. The Fed started offering explicit forward policy guidance in the early 2000s, and further embraced this practice when rates hovered near the zero lower bound after the financial crisis. A reasonable amount of historical precedent exists for the evolution of forward guidance during economic and rate cycles. Against that historical record, the shift in the FOMC’s forward guidance at its most recent meeting marks a drastic swing out of step with Fed behavior in prior episodes. It’s possible the Fed may have jumped the gun on a pause this week and will have to flip-flop later in the year.

1999-2001 cycle

The Federal Reserve only began to issue statements after policy rate changes in 1994, and they were mainly just to inform the market of the Committee’s decision in the early years.  By the late 1990s, the statements had expanded to include a few sentences describing the current situation as a way of providing a justification for Fed moves.  At the beginning of 2000, the Committee instituted a new communications policy, agreeing to issue a statement after every meeting, even if there was no change to policy, and to offer an assessment of whether the balance of risks was skewed toward economic weakness or higher inflation.

That innovation came in handy as 2000-2001 proved quite tumultuous.  The Fed began raising rates in 2000, reaching what would prove to be the peak of the rate cycle in May with a funds rate of 6.5%.  For several meetings after May, the FOMC still characterized the balance of risks as skewed to higher inflation.  In November 2000, the Fed acknowledged some economic softening but still viewed the risks as weighted toward higher inflation.  In December, the FOMC flipped the balance of risks toward economic weakness, and about two weeks later, the Committee eased for the first time in what would prove to be a series of moves over the course of the year.

This cautious approach to the turn in the economic/rate cycle has generally proven to be the norm historically.  In the past, when consumer price inflation was more of a threat, the Fed was often put in the difficult position of having to maintain a restrictive stance even after the economy shows signs of weakening, as inflation has historically tended to lag relevant measures of economic activity.

2003-2006 episode

In 2003, the Federal Reserve had pushed the funds rate down to 1% and was still concerned that core inflation was running lower than its target.  At that time, the Committee chose to augment the balance of risks assessment with an assurance that “the Committee believes that policy accommodation can be maintained for a considerable period.”  This began the use of explicit forward guidance by the Fed.  Policymakers felt that they needed to reassure market participants that there would be no rate hikes for a while as a way to further ensure that the economy did not slide into a Japanese-style deflationary morass.

The disinflationary/deflationary scare proved fleeting, as the economy picked up momentum and core inflation quickly began to creep higher.  By January 2004, the balance of risks assessment was brought into balance, and the forward guidance was changed to “the Committee believes that it can be patient in removing its policy accommodation.”  In May of that year, the forward guidance was tweaked to “the Committee believes that policy accommodation can be removed at a pace that is likely to be measured,” accurately signaling an imminent rate hike; the first rate hike in the cycle occurred at the next FOMC meeting in June.

The “measured pace” language, which came to be understood to mean a 25 bp rate hike at every FOMC meeting, was left in place throughout the first 12 rate hikes of the cycle.  Finally, in December 2005, the FOMC began to soften the forward guidance, noting that “the Committee judges that some further measured policy firming is likely to be needed,” signaling that the rate hikes were likely nearing an end.  At Chairman Greenspan’s last meeting in January 2006, that language was altered to read “some further policy firming may be needed,” a marginal softening of the forward guidance.  Two meetings and two rate hikes later, in May, the word “yet” was added (“some further policy firming may yet be needed”) to further water down the bias toward more rate hikes.

2006-2008 swing to ease

When the Fed implemented what would ultimately be the seventeenth and final rate hike of the cycle, the statement dropped the “further policy firming” construction altogether and was left with this: “the extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth,” suggesting that the FOMC had a tightening bias but was not sure that more rate increases would prove necessary.

This guidance was maintained until March 2007, when the directionality bias was softened.  The new forward guidance maintained that “the predominant policy concern remains the risk that inflation will fail to moderate as expected,” a cousin of the original balance of risks framework introduced in 2000.  However, the “extent and timing of any additional firming” was changed to “future policy adjustments,” introducing more of a symmetry with respect to prospective future policy moves.

That language, perhaps a “soft” tightening bias, was retained through August, the last FOMC meeting before an epic easing cycle began.  Conditions deteriorated rapidly, and the Fed was forced to cut rates by 50 bp in September.  However, the FOMC did not shift to a clear downside skew in the balance of risks until January 2008, by which time it had already eased 175 bp.

In March 2008, having slashed the funds rate target by 300 bp in six months to 2.25%, the FOMC hopefully suggested that it might be done, noting that “today’s policy action, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity.”

That rough neutrality held through the summer before the bottom dropped out of the economy and the financial markets in September and October, sparking a race to zero over the balance of 2008.

Current cycle

After using forward guidance extensively during the period when rates were at the zero lower bound, the usefulness of this tool has diminished as the policy stance has moved back toward normal.  Thus, the Fed began to dismantle the multiple layers of forward guidance in the FOMC statement about a year ago, coinciding roughly with the changeover in leadership at the Fed to Chairman Powell.

The removal of the last major bit of forward guidance at the most recent FOMC meeting was not surprising, as Fed officials, including Powell, had discussed extensively that they wanted to get away from forward guidance and back to a more data-dependent stance.  Powell noted late last year that with the current policy rate approaching the bottom end of the range of estimates of neutral, the Committee no longer needed to have a strong presumption about where policy was headed, even though he did note that policy typically moves beyond neutral to a modestly restrictive stance near the end of a rate hike cycle.  This discussion sounded an awful lot like the “some further policy firming” language that was used around the time that the 2004-2006 tightening cycle ended.

By January, however, the FOMC had jumped ahead by several steps.  Having just hiked rates in December, the Committee moved to full-on symmetric forward guidance language, using the same word “adjustments” that was deployed in March 2007, only after nine months of no rate moves by the Fed and only six months before the first ease.  Even then, however, the 2007 statements included a balance of risks skewed toward inflation concerns.  The January 2019 statement language is closest to the language used in August and September 2007, just as the Fed was beginning to cut rates, and to the shift in the balance of risks seen in the November-December 2000 period, again, just a month or two before the Fed began to ease.


Does the shift in language imply that the Fed thinks that an ease is imminent?  That was not the tone struck by Powell at his press conference, and the January 2019 statement noted that the Fed would be “patient,” pointing to a significant period of time during which the Fed will be on the sidelines. Thus, the Fed’s behavior at the most recent FOMC meeting is well out of step with the patterns established during previous episodes when policy was transitioning potentially from rate hikes to cuts. This is especially so considering that the FOMC apparently still believes that economic growth will remain well above trend in 2019 and that the unemployment rate will continue to fall further below its best guess of long-run equilibrium.  Historically, such an economic environment would have generated a period of at least several months when some sort of upside bias in the FOMC’s forward guidance/balance of risks language remained after the Fed paused or stopped tightening.

Perhaps the FOMC was spooked by the financial market moves late last year and feels that it has to go out of its way to be far more dovish than the economic data would normally warrant to soothe the markets; or maybe the FOMC is simply far more dovish than it has historically been.  Either of these hypotheses is plausible, and both could be true.

There is one key difference between the current cycle and the historical episodes detailed above that also may have an important bearing on the FOMC’s precedent-breaking behavior. The Fed, rightly or wrongly, is not at all worried about inflation exceeding its target this time around. As Powell noted at his press conference, with inflation seemingly under control and financial conditions no longer suggesting overheating, the Fed appears to believe that there is little to no downside to erring on the side of relatively easy policy, a luxury that Powell’s predecessors have not had since before the Great Inflation of the 1970s.

This change in the FOMC’s perceived relative risks of policy errors further extends the pattern seen in recent history of the Fed easing aggressively, staying accommodative longer than before, and then moving to a progressively less restrictive stance at the top of each successive rate cycle. In this instance the Fed may have jumped the gun and will have to flip-flop later in the year when the economy continues to perform vigorously, a circumstance that the Fed in the past seems to have been more determined to avoid. Only time will tell whether the Fed’s unprecedentedly aggressive rhetorical turn was a bold stroke of genius or a false step.

john.killian@santander.us 1 (646) 776-7714

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