With the release of the March FOMC minutes, many investors have been trying to decipher how and when the Fed may make their next move. What is confusing to many is that the Fed’s official statements on the economy and the direction of policy do not always seem consistent with the speeches and comments made by individual FOMC members. Some people are surprised to learn that within the Fed there are actually a wide range of views on where the economy is and what should be done to keep it growing. The Fed tends to put out guidance that represents the central views of the members, but it is by no means unanimous.
To get a better sense of this, let’s look at the “dots” from the recent meeting minutes. Along with the minutes, the Fed posts the level of the federal funds rate that each member thinks is appropriate at different points in time, wrapped up in a chart called “appropriate pace of policy firming”. This is where the dots come in. Each member’s view is represented by an individual dot, giving us 16 different opinions on where the federal funds rate should be at the end of 2014 and in the future. These individual dots paint a very interesting picture. It reveals that within the Fed there is a wide range of views on the current state of the economy and on the correct future path of Fed policy.
Below is the dot plot from the March minutes. Looking at 2014 we see that most of the indications are for 0-25 basis points (bps), consistent with current policy. But there is one indication of one percent. Sure, that’s only one out of the 16 participants, but it is still a big difference. That voter may believe that a) growth or inflation will spike up in the near term and the Fed needs to get ahead of that change, or b) the current low interest rate policy is not appropriate and short rates should be increased to more normal levels soon. I think that “b” is the more likely of the two, but either way that individual member is taking a much more aggressive stance than their 15 colleagues.
Now look at 2015, where the range is from zero to three percent. Two participants think that the federal funds rate should stay right where it is until the end of 2015. And one participant is calling for a rate that is three percent higher than it is today. That is a pretty significant spread. The more conservative members are essentially saying that the Fed will need to raise short term interest rates by 25 bps at each of the eight meetings in 2015.
For 2016 we see an even more spread out distribution than 2014 or 2015. One voter is calling for 0.75 percent, while another is calling for 4.25 percent. The other 14 participants are sprinkled in a range in between. If we assume that the most hawkish participants remain hawkish between 2015 and 2016, and the doves remain doves, then the pace of tightening could be a bit slower than what is expected in 2015.
We only see opinions begin to converge when looking at the “longer run” estimate. This is a narrow range of 3.5 to 4.25 percent, and represents the market equilibrium federal funds rate that should be in place when the economy is in balance. So there is relative alignment on where we are going, it’s the path and speed that are so different.
Personally, I like to think of the federal funds rate as a gas pedal. The “longer run” rate represents the amount of stimulus, or fuel, necessary to keep the economy growing at the same rate. Lower rates represent stimulus to the economy, a pressing of the gas pedal. Higher rates represent slowing down, either by taking the foot off the gas or hitting the brake. Thinking about policy in this framework helps to explain the Fed’s movements. When we do start to move from the current level of rates up to 25 bps it will not initially represent slowing down the economy, but rather providing less gas and growth by easing off the pedal. It is only when we breach the longer run level of around 4% that the Fed really begins to apply the brakes. And that is likely a few years off.
So what does this mean for investors? I think that there are 3 important things to keep in mind:
- Remember that there is a wide range of opinion within the Fed. The average is important, but watch the participant rate range to get a sense for how much uncertainty there may be in future policy.
- Only 3 of the FOMC participants expect that we will reach the “longer run” range by the end of 2016. As a result, it is likely that the Fed will still be in tightening mode into 2017.
- Think of the federal funds rate as a gas pedal. Sometimes it makes sense to ease up a bit, if only to accelerate less quickly. Unless the Fed stomps on the brakes and brings the federal funds rate above the “longer run” policy rate, then what we are really talking about is just a range of acceleration.