The Fed and its "extended period" language

Will they / won’t they? All eyes will be on the Fed statement issued around 2pm EST Wednesday to see if there is any change to the “extended period” language the US central bank uses to guide market expectations of the future path of interest rates (last FOMC statement).

The current formula is as follows: “the Committee…continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” Translated from Fedspeak: the committee does not expect to raise interest rates from the current level of near zero for a period some officials define as at least six months, others as longer than this.

As I first reported in the FT ten days ago – and my excellent competitor Jon Hilsenrath of the WSJ subsequently confirmed – Fed officials are starting to mull changing the “extended period” language. I/we know this for a fact. The question is whether they are far enough along in this process to make a change at this meeting.

Unlike most analysts, I don’t think we can rule this out. But I do agree that the likelihood of a change this time is a good deal less than 50-50 – for two reasons: a) internal debate on this subject - which only recently got going – is lively and may not be ripe for resolution; b) I believe that the Fed will prepare the ground for a statement change through speeches, testimony and/or minutes first in order to minimise the risk that it is misinterpreted by the market.

If there is a change at this meeting it is likely to come by way of policymakers adding conditionality to the “extended period” phrase rather than by way of diluting the time frame from “extended period” to, for example, “some time”. A conditional qualifier would be easier to agree at this stage and might not require explanation in advance.

Allow me to elaborate – with the caveat that this post is based on my own evaluation and not any eleventh hour tip-off from chairman Bernanke (trust me: that isn’t how it works).

Mainstream officials think the time has come when they need to start thinking about scaling back the “extended period” language. They worry that this implies a false degree of certainty as to their own expectations for the path of interest rates.

Mainstream officials do not expect to raise rates in the next six months, but think there is a chance they may have to do so. They do not want to be boxed in by their guidance and would like the statement to give a better sense of the range of possible outcomes and the way they would respond to different developments – i.e. their reaction function.

This could be helpful with respect to the dollar and inflation expectations. Indeed, conveying a proper sense of uncertainty about rates – and the circumstances that could lead to early Fed rate increases – might make it less likely that events unfold in a way that obliges the Fed to raise rates in the first half of next year.

But mainstream officials are sensitive to the argument that if the US central bank changes its guidance language the market will simply price in more tightening. Some senior doves are very concerned about this. This suggests the Fed will move carefully. I am not sure the internal debate has played out far enough for the Fed to reach consensus on a change by 2pm Wednesday.

Moreover, I think Bernanke would like to explain the context for a shift in the guidance before it takes place, in order to ensure that it is not misconstrued as a sign of imminent tightening. As I wrote in my original article in the FT ten days ago: ”The Fed is likely to prepare the ground for a statement change through speeches or testimony first.”

In governance and communications terms the logical sequence is as follows: 1) Policymakers start a formal discussion around the “extended period” language at the FOMC level but do not immediately change the statement; 2) Minutes reveal the discussion and rehearse the arguments; 3) Mr Bernanke gives a speech or testimony in which he explains how the Fed is thinking about this issue and how the market should interpret any changes; 4) The FOMC changes the statement.

Putting a timeline around this is tricky. I expect that the formal discussion about the “extended period” language started at this week’s FOMC meeting though I do not know that for a fact. The four steps outlined above could be complete in time for a statement change at the December FOMC or they could be stretched out into the early New Year. If I am right, look to see the first hard evidence of this process in the minutes of the current meeting.

Note, however, that not all language changes are made equal. There are two basic options - to add conditionality/context to the guidance or to shorten the time period for which it applies e.g. from an “extended period” to “some time.” The threshold for the former is much lower than the threshold for the latter.

It is not impossible that Fed hawks and doves could agree now to qualify the “extended period” guidance with a conditional phrase. It could be something simple like “providing the economic outlook evolves along the lines set out in our forecast and inflation expectations remain contained…” Or it could be a bit more detailed and specific.

A conditional qualifier might not require extensive explanation in advance, though I think the Fed would still ideally like to explain the context ahead of time. That is why I think there is some chance of a statement change at this meeting.

It would be a much bigger deal to change from an “extended period” to “some time” as this type of shift would directly imply that the committee is no longer as confident as it was that it will still be on hold six months or so from now.

So if there is to be a change on Wednesday I think adding a conditional qualifier is more likely than diluting the time period. Conversely, the longer the Fed waits, the stronger the case for changing the time frame rather than just adding a qualifier.

It may not be easy for the Fed to agree even on a qualifying clause, however. Such a clause would explicitly or implicitly sketch out the circumstances that would lead the Fed to raise rates in the next six months.

Policymakers might well struggle to agree ex ante on how to describe these, given the multiple combinations of factors that could give rise to inflation risk and disagreement within the committee over the nature of the inflation process.

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