The Key to Understanding Fed Monetary Policy

The key to understanding Fed monetary policy is to realize the primary impact is through forward guidance.  Currently, it is more important to focus on the Fed's projection of the funds rate than whether it raises the funds rate by 25 BPs.  The latter would be more a catch-up to their projection than a policy change.  This way of evaluating Fed policy explains why the markets have moved so much after what was viewed as a modest 25 BP hike in December 2015.  The markets reacted to the Fed's projection of 4 hikes in 2016, not the actual 25 BP hike.

This way of looking at Fed monetary policy means that what will matter at the March 15-16 FOMC Meeting is whether the trajectory of the "dots" -- the projected funds rates -- changes.  If the Fed skips a March rate hike but the trajectory remains the same as before,  any market relief should be short-lived.  The forward guidance for the future path of the Federal funds rate will be what is important.

Many market participants would say "Wait! Isn't the fed funds futures market building in at most 2 hikes in 2016?"  The answer is that the Fed's projection has impacted all the markets -- stocks, fixed income, currencies and commodities -- and the combined impact reflects the expectation of 4 hikes.  This is observable from some Street calculations of the Financial Conditions Index showing a drop equivalent to 4 25 BP rate hikes.  The likely net economic drag from all these different channels of policy has weighed on the fed funds futures market, which embodies the expectation that the Fed will not follow through with all 4 hikes as a result.

The idea that forward guidance is what matters hearkens back to the debate surrounding Quantitative Easing.  When this was implemented a few years ago, market participants argued whether QE operated through the "flow" of monthly purchases by the Fed or through the initial announcement of the total amount of Treasuries to be purchased.   Fed staff determined that the initial announcement is how it works.  Similarly, it would seem that the Fed's announcement of its expectation for the entire funds rate trajectory is more important than any particular 25 BP hike that is part of that trajectory.

Carl Palash
February 8, 2016