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.

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