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Feeling ignored, Fed jolts markets to prime them for lift-off

NEW YORK/SAN FRANCISCO/WASHINGTON (Reuters) – When the U.S. Federal Reserve tweaked its policy statement last week and put a December rate rise squarely back in play, it took a calculated gamble that reaching for an old and controversial policy tool would get financial markets’ attention.

That gamble was to specifically reference the next policy meeting as a date of a possible lift-off, and it had the desired effect: investors quickly rolled back bets that rates would stay near zero until next year.

But interviews with current and former Fed officials, and with those close to policymakers, show the decision to use what is called calendar guidance in central bank parlance and what some described as a “hammer” did not come easy. Some officials felt that even mentioning a date in the context of a potential policy change would be taken not as a contingent expectation but as a promise that would be painful to break.

The last time the Fed flagged its next meeting for possible action was in 1999, as JPMorgan economist Michael Feroli pointed out. It resorted to calendar-based commitments of ultra-easy policy during the global financial crisis and recession, but ended that practice three years ago.

Yet Fed Chair Janet Yellen and her deputies got so frustrated that investors virtually ignored their message that a rate rise before the year end was probable that they decided last month it was a risk worth taking, the interviews show.

As a result, futures markets are now giving slightly better-than-even odds that rates will rise from near zero next month, compared with mid-October when the odds were less than 30 percent.

Fed officials and people familiar with their thinking say the central bank is comfortable with such market expectations ahead of the Dec. 15-16 policy meeting, the last of the year.

Last week’s communication gambit, one of Yellen’s biggest in nearly two years as Fed chief, suggests the central bank still considers a modest rate rise this year as its base scenario.

TIMELY FASHION

It may also suggests that Fed policymakers are already lining up behind Yellen despite public comments that can sound at odds with her message. The Oct. 28 statement was passed by a 9-1 vote, with two Fed governors who had earlier publicly embraced a delay in rate hikes joining the majority.

“If a majority still believed that such a move would be premature, then they could have just left the wording unchanged from their previous statement,” said Andrew Levin, former advisor to Yellen and Dartmouth College economist.

Yellen herself reiterated on Wednesday that a “lift-off” this year remained her preferred option, when she told the House Financial Services Committee that “moving in a timely fashion” was prudent so long as the economy continued to perform the way it had so far.

And while the slackening growth in monthly payrolls convinced some investors that the Fed should wait, several policymakers have been pointing out that slackening jobs was in fact a sign that the labor market recovery was nearly over.

Investors and economists who advocate more patience warn of a risks of market turbulence if the Fed lifts its rates while its peers in Europe, Japan, China and elsewhere are in an easing mode. With rates having been near zero since late 2008, even a small move is expected to ripple through global markets, boosting the dollar and drawing funds out of emerging markets.

In fact, a brief but sharp market sell-off in August triggered by a slowdown in China and fears of a global economic chill persuaded the Fed to leave rates steady in September. The decision, even though described as a “close call” by some policymakers, led many investors to pare down their bets on a rate rise this year.

Since then, Yellen, her deputy Stanley Fischer and New York Fed President William Dudley had set out to reinforce the message that a gradual rise in rates would likely begin before year end, in part because of an expected recovery in inflation thanks to stabilizing oil prices.

But Yellen’s Sept. 24 speech, seen as crucial for conveying that message, got drowned in the attention her health drew after she struggled to finish the speech and received medical assistance.

BLURRED MESSAGE

Later a set of weak U.S. data and comments from Lael Brainard and Daniel Tarullo, two influential Fed governors close to Yellen, urging patience on rates, further blurred the picture and intensified criticism of the Fed’s communication.

On Oct. 16, Dudley got an earful from Wall Street bankers and economists on a New York Fed advisory panel criticizing the Fed for its muddled message, according to three people who attended the meeting.

The interviews with Fed officials and those close to the central bank suggest that it was around this time that the plan to hint at December in the next policy statement started taking shape.

Yellen, her deputies, and a few top staffers typically write the first draft of the statement two weeks before the policy meeting.

A so-called teal book effectively formalizes the language a week later with feedback from other Fed presidents and governors.

Some Fed officials were uncomfortable with the “innovation,” said a source with knowledge of how the decision was made, but they agreed to back it because “there was a sense that the market wasn’t listening.”

The December reference is not a commitment to a rate rise next month since the decision will still depend on whether economic developments will confirm or derail the Fed’s medium-term expectations for jobs, growth and prices, the sources said.

But the language allows both hawks and doves to endorse it, and buys Yellen time to rally them around her plans while honing the Fed’s message.

“It’s a tactical decision for Janet Yellen,” said Vincent Reinhart, an economist with the American Enterprise Institute and former chief of the Fed’s monetary affairs division.

“You will buy off some of your more hawkish colleagues by reassuring them that you are willing to tighten, and you will buy off the dovish colleagues by convincing them that you can remain accommodative longer by starting sooner.”