Fed funds rate: lower for even longer

The US Federal Open Market Committee (FOMC) has issued a policy statement that pushes out the expected period of exceptionally low Fed funds rates from mid-2013 to 'late 2014'. Indeed, more members of the committee think the first increase in the rate will be in 2015 than in either this year or next, and some do not expect a rise until at least 2016.

The US rate-setting committee has also released projections of members’ estimates of the appropriate level for the Fed funds rate – currently 0.25 per cent – at the end of each of the next three years. Given current and expected economic conditions, a majority – 11 of the 17 – believed the rate should still be 1 per cent or less at the end of 2014.

And a further policy document from the FOMC sets out the rationale for adopting an explicit longer-run goal for inflation of 2 per cent. The committee said that communicating this inflation goal clearly to the public should anchor inflation expectations and promote maximum employment.

The statement implied that the commitment to a 2 per cent inflation target will help maintain employment in the face of significant downward shifts in demand. At the same time, the document explained that the policymakers believe they cannot adopt an explicit long-run target for the unemployment rate because the factors determining the maximum level of employment over the long run are beyond the Fed’s control.

The committee said that communicating this inflation goal clearly to the public should anchor inflation expectations and promote maximum employment.

Nonetheless, the FOMC members expressed their views on the best estimate of the current normal long-run rate of unemployment. Their central tendency estimate is from 5.2 per cent to 6.0 per cent. This is an increase from an estimate of 4.8 per cent to 5.2 per cent made in January 2009.

The US unemployment rate averaged 8.7 per cent in the fourth quarter of 2011. Clearly, the majority of the FOMC members regarded this as too high, particularly relative to their estimate of the ‘normal’ rate of roughly 5.6 per cent. In addition, the majority said the unemployment rate will come down only slowly over the next few years. The central tendency forecasts of unemployment for 2014 were in a range of 6.7 per cent to 7.6 per cent: so the midpoint of that range, 7.2 per cent, would still be high relative to a 5.6 per cent long-run normal rate.

Meanwhile, the central tendency estimates put the rate of inflation in a range of about 1.5 per cent to 2.0 per cent for the next three years. This means inflation would be at, or slightly below, the FOMC’s longer-run goal of 2 per cent.

With inflation subdued and unemployment higher than desired, the rationale for the latest easing move is clear. The policy statement and the statement regarding longer-term goals and strategy made no mention of quantitative easing (QE) as a policy tool. However, questions about QE came up several times in Fed Chairman Ben Bernanke’s press conference following the conclusion of January’s FOMC meeting and he made it clear that QE was still an option being considered by the committee.

He stated that if the recovery falters and inflation is not moving toward the 2 per cent target, then additional QE will be considered. He did not suggest the committee was actively considering a move toward QE, but he made it clear that if the unemployment rate does not move lower, and if inflation remains below 2 per cent, then another QE programme could be launched this year.

The Fed's guidance that a tightening move is unlikely until at least late 2014 – and the view of six members that a first tightening move is unlikely before 2015 or 2016 – is consistent with the HSBC fixed income strategy's expectations of 'lower for longer' for the funds rate. But the implications of the more-dovish stance by the Fed will create some headwinds for the dollar.

Past Fed easing initiatives, particularly the two rounds of QE in 2009 and 2010-11, were accompanied by considerable weakening in the dollar. That, in turn, drew sharp criticism from some global policymakers who asserted that the Fed was intentionally attempting to devalue the US currency.

That was the premise of the 'currency wars' accusations that have been an occasional theme in the foreign exchange market since the inception of the financial crisis more than four years ago. This latest action by the Fed could eventually lead to similar sentiments developing again in an environment of weak global demand and growth, and where maintaining a competitive currency is a desirable, if not overtly stated, objective for many countries.

This report must be read with the disclosures, analyst certifications and the disclaimer.