FOMC Preview: How Markets Were Guided Before the Last Rate Normalization
September 16, 2014
Fed officials have already prepared investors to expect a change in forward policy guidance language that will steer markets to an initial Fed funds rate hike around next March or April. Rate normalization will then commence, by which is meant the transformation of policy from the current stance that promotes faster economic growth and higher inflation to a configuration that neither augments nor exerts a drag on the economy.
The last period of rate normalization occurred during the two years between mid-2004 and mid-2006. At 17 consecutive FOMC meetings, the interest rate was raised by 25 basis points each time, lifting the rate level to 5.25% from 1.00%. Note that none of the current voting Federal Open Market Committee members were in that capacity in mid-2004. This is an entirely different set of policymakers, but the existence of institutional memory means there could and likely will be some similarities in how forward policy guidance is handled this time versus last time. A second point to bear in mind is that in the wake of the Great Recession and structural demographic changes in the labor force, the neutral level of the Fed funds rate is much lower now than then. The eventual fed funds rate target is apt to range between 3.25% and 4.25%.
At the penultimate FOMC meeting of 2003, officials still perceived balanced risks to economic growth but unequal risks to future inflation. Too low inflation was identified as their predominant concern for the foreseeable future, and they said policy accommodation can be maintained for a considerable period. But after the December meeting of 2003, the released statement said downside risks to inflation had diminished and were almost the same as upside risks. It was noted that inflation risks are low, and resource slack was still abundant. So, the sentence was retained that policy accommodation could be maintained for a considerable period. The December 2003 meeting was equivalent to the one this week from the standpoint of readying markets for change.
At the first meeting of 2004, a change was introduced to the final sentence in the paragraph dealing with forward guidance. The Fed could “be patient in removing its policy accommodation.” The second meeting of 2004 in mid-March did not modify forward guidance further. The third meeting, however, effectively cocked the rate hike pistol. Balance had been achieved between upside and downside inflation risks, and the statement concluded that “policy accommodation can be removed at a pace that is likely to be measured.”
A couple of language changes accompanied the first rate hike on June 30, 2004. Instead of calling inflation low, the statement predicted that core inflation was likely to be relatively low. A reference to slack capacity was deleted, and the statement added a promise to “respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.”
Long-term interest rates handled the Fed policy normalization of 2004-06 in much greater stride than had been the case in the previous major policy normalization of 1994-5. Core CPI inflation rose gently between mid-2004 and mid-2005, mostly during the second half of the period. The 10-year U.S. treasury yield was at 4.63% when the process began, 3.96% one year later and 5.20% in mid-2006 when the sequence of measured 25-basis point increases ended. The yield record similar period averages of 4.29% in the first half of 2004, 4.23% in the second half of 2004, 4.22% in the first half of 2005, and 4.34% in the second half of that year. The average jumped a little less than a half percentage point to 4.81% in 1H06. The trend was downward during the second half of 2006, but the 10-year average of 4.76% almost matched the first-half mean. Broadly speaking, the yield curve sloped sharply upward at the start of the normalization but was moderately inverted at the end. Nonetheless, the 5.25% level was maintained until September 2007. Fed officials, like most private-sector economists had not seen the Great Recession coming.
The table below compares some current vital U.S. market signs to their levels at previous FOMC meetings going back to the last policy normalization. Since the last meeting on July 30, the dollar has strengthened against the euro and yen. Long-term interest rates have risen but less than one might guess because such initially fell. Stocks are modestly higher on balance, and the price of oil has dropped.
EUR/$ | $/JPY | 10Y, % | DJIA | Oil, $ | |
06/30/04 | 1.2173 | 109.44 | 4.63 | 10396 | 37.95 |
06/30/05 | 1.2090 | 110.89 | 3.96 | 10370 | 57.00 |
06/29/06 | 1.2527 | 116.07 | 5.20 | 11077 | 73.41 |
06/28/07 | 1.3452 | 123.17 | 5.10 | 13456 | 69.82 |
08/07/07 | 1.3749 | 118.55 | 4.73 | 13510 | 72.27 |
09/18/07 | 1.3888 | 115.75 | 4.51 | 13475 | 81.42 |
10/31/07 | 1.4458 | 115.28 | 4.42 | 13873 | 93.59 |
12/11/07 | 1.4682 | 111.49 | 4.11 | 13645 | 89.78 |
01/30/08 | 1.4792 | 107.31 | 3.70 | 12454 | 91.70 |
03/18/08 | 1.5786 | 98.73 | 3.41 | 12257 | 107.53 |
04/30/08 | 1.5562 | 104.58 | 3.83 | 12953 | 111.54 |
06/25/08 | 1.5568 | 108.37 | 4.18 | 11837 | 133.62 |
08/05/08 | 1.5445 | 108.42 | 3.97 | 11484 | 119.82 |
09/16/08 | 1.4144 | 105.16 | 3.36 | 10936 | 91.18 |
10/08/08 | 1.3625 | 99.87 | 3.50 | 9447 | 87.02 |
10/29/08 | 1.2933 | 97.15 | 3.81 | 9145 | 67.38 |
12/16/08 | 1.3790 | 90.14 | 2.52 | 8687 | 44.14 |
01/28/09 | 1.3253 | 90.01 | 2.61 | 8356 | 42.92 |
03/18/09 | 1.3115 | 98.13 | 2.94 | 7340 | 47.73 |
04/29/09 | 1.3331 | 97.06 | 3.02 | 8194 | 51.05 |
06/24/09 | 1.3984 | 95.43 | 3.59 | 8373 | 68.76 |
08/12/09 | 1.4221 | 96.17 | 3.71 | 9366 | 70.64 |
09/23/09 | 1.4779 | 91.50 | 3.50 | 9859 | 69.13 |
11/04/09 | 1.4884 | 90.75 | 3.51 | 9896 | 80.66 |
12/16/09 | 1.4542 | 89.78 | 3.56 | 10478 | 73.14 |
01/27/10 | 1.4045 | 89.49 | 3.61 | 10148 | 73.31 |
03/16/10 | 1.3756 | 90.64 | 3.67 | 10645 | 81.45 |
04/28/10 | 1.3157 | 94.10 | 3.75 | 11043 | 82.57 |
06/23/10 | 1.2284 | 90.12 | 3.13 | 10307 | 76.50 |
08/10/10 | 1.3107 | 85.85 | 2.81 | 10605 | 79.94 |
09/21/10 | 1.3132 | 85.21 | 2.66 | 10747 | 73.05 |
11/03/10 | 1.4059 | 81.35 | 2.53 | 11174 | 84.59 |
12/14/10 | 1.3423 | 83.37 | 3.38 | 11497 | 88.47 |
01/26/11 | 1.3658 | 82.55 | 3.41 | 12001 | 87.36 |
03/15/11 | 1.3969 | 81.04 | 3.29 | 11815 | 98.09 |
04/27/11 | 1.4665 | 82.63 | 3.36 | 12612 | 112.48 |
06/22/11 | 1.4392 | 80.12 | 2.97 | 12175 | 94.87 |
08/09/11 | 1.4234 | 77.09 | 2.36 | 10993 | 81.76 |
09/21/11 | 1.3778 | 76.34 | 1.93 | 11377 | 86.74 |
11/02/11 | 1.3724 | 78.11 | 2.03 | 11805 | 92.77 |
12/13/11 | 1.3067 | 77.92 | 1.98 | 12130 | 100.20 |
01/25/12 | 1.3027 | 77.96 | 1.97 | 12670 | 98.85 |
03/13/12 | 1.3096 | 82.76 | 2.08 | 13044 | 106.34 |
04/25/12 | 1.3226 | 81.37 | 1.97 | 13096 | 104.13 |
06/20/12 | 1.2693 | 79.28 | 1.66 | 12837 | 83.63 |
08/01/12 | 1.2300 | 78.10 | 1.49 | 13028 | 88.98 |
09/13/12 | 1.2895 | 77.43 | 1.72 | 13342 | 97.60 |
10/24/12 | 1.2948 | 79.75 | 1.77 | 13115 | 85.72 |
12/12/12 | 1.3082 | 83.24 | 1.70 | 13325 | 87.13 |
01/30/13 | 1.3584 | 91.16 | 2.02 | 13949 | 97.63 |
03/20/13 | 1.2948 | 95.65 | 1.94 | 14497 | 92.82 |
05/01/13 | 1.3195 | 97.48 | 1.62 | 14740 | 90.47 |
06/19/13 | 1.3364 | 95.76 | 2.23 | 15304 | 98.38 |
07/31/13 | 1.3301 | 97.92 | 2.67 | 15565 | 105.63 |
09/18/13 | 1.3363 | 98.28 | 2.76 | 15606 | 107.01 |
10/30/13 | 1.3764 | 98.18 | 2.48 | 15660 | 97.42 |
12/18/13 | 1.3696 | 103.81 | 2.89 | 16198 | 98.06 |
01/29/14 | 1.3651 | 102.13 | 2.73 | 15719 | 97.23 |
03/19/14 | 1.3918 | 101.75 | 2.71 | 16335 | 99.96 |
04/30/14 | 1.3868 | 102.11 | 2.66 | 16553 | 99.52 |
06/18/14 | 1.3584 | 101.93 | 2.61 | 16892 | 106.12 |
07/30/14 | 1.3380 | 102.91 | 2.55 | 16853 | 100.19 |
09/16/14 | 1.2943 | 107.18 | 2.58 | 17024 | 93.77 |
Copyright 2014, Larry Greenberg. All rights reserved. No secondary distribution without express permission.
Tags: FOMC preview