Monetary Policy: A Statement of Confidence?
Yesterday, the Federal Open Market Committee (FOMC) left the target level of the federal funds rate unchanged at 5.25 percent, as markets had expected. It was the sixth consecutive meeting with no change. The inflation-adjusted fed funds rate remains near 3 percent, or about 400 basis points above its low of June 2004.
While financial market participants were virtually unanimous in their expectation that rates would be unchanged, it was not clear how they would react to changes in the language of the policy statement released at the end of the meeting. Incoming data during the intermeeting period suggested that the outlook for both the economy and inflation had changed if only marginally.
In January, the statement noted that
“Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market. … Readings on core inflation have improved modestly in recent months, and inflation pressures seem likely to moderate over time.”
In subsequent weeks, however, new information did not support the prospect for somewhat firmer economic growth and improved inflation conditions, necessitating a change in the language. Yesterday’s statement was modified accordingly:
“Recent indicators have been mixed and the adjustment in the housing sector is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters. … Recent readings on core inflation have been somewhat elevated. Although inflation pressures seem likely to moderate over time, the high level of resource utilization has the potential to sustain those pressures.”
Since last August, the FOMC’s postmeeting statements have also included the qualification,
“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, as implied by incoming information.”
This language has been interpreted as a tightening bias. Although the new language made clear that “...the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected,” the statement from March’s meeting dropped any reference to “additional firming,” a move interpreted by some as a lessening if not a removal of the tightening bias.
On the face of it, the FOMC’s previous assessment of inflation risk might suggest to some that a rate hike would be more likely than a rate cut. The view inferred from market prices on futures and options, however, continues to suggest an alternative expectation. Implied yields based on fed funds futures prices since last summer have generally projected a decline in the policy rate. According to some market commentators, the new language seemed to be more consistent with market expectations.
Estimated probabilities derived from prices of options on federal funds indicate that the FOMC is still not likely to change its policy setting before late summer. Although the probability of a rate cut increased in response to the statement, the odds remain better than 50-50 that the policy rate will remain at 5.25 percent after the meeting in June.
Although bond yields dropped sharply from their premeeting highs, they ended up largely unchanged on the day. The two-year Treasury rate closed about 8 basis points lower. The level of interest rates at different maturities—commonly called the yield curve—flattened very modestly, but remained generally negative. Although negative yield curves have been associated with subsequent slowing in economic growth, equity market participants have seemed largely unfazed by the bond market indicator. Equity prices rallied sharply after the release of the policy statement, ending up about 1-1/2 percent higher on the day. Despite the uncertainty conveyed in the language, the stock market offered its own statement—one of confidence.