When the Federal Reserve cut interest rates to virtually zero in December last year, it told the market it expected to keep them there for quite a while.
The message was in a key line in the Fed statement that said “weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time”. The idea was to give additional stimulus by lowering market expectations of the future path of interest rates.
In March, the Fed went a step further and said the committee “anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period”.
Ever since, the US central bank has stuck with the “extended period” phrase – indicating policymakers see little likelihood that interest rates will rise over a time frame that has never been defined, but some see as at least six months.
But now senior officials are starting to mull changing the statement in a way that would soften this guidance. That would be a natural step in the slow glide- path towards eventual policy normalisation.
Importantly, however, it would also give the central bank greater flexibility to respond to inflation risks if they escalate in a way the Fed does not expect but cannot rule out.
Strictly speaking, the “extended period” guidance is not a commitment but a forecast: it spells out what the Fed expects to do based on current information, rather than what it will do in all circumstances.
Nonetheless, the Fed wants to avoid a situation in which it might be forced to move quickly from forecasting an “extended period” of rates held near zero to raising rates, as that would disrupt markets and damage its credibility.
At the same time, policymakers worry that changing the “extended period” language could be misinterpreted as a signal that rate rises are imminent when they are not.
Most mainstream officials still do not expect to raise interest rates before the second half of next year. But this assumes that the economy evolves along the lines of the Fed’s base-case forecast – with a weak rebound, subdued inflation and no escalation of inflation threats.
There is uncertainty around that forecast, however. While Fed hawks and doves emphasise different risks, most could sign up
to these three propositions:
First, spare capacity should exert significant downward pressure on prices, though it is hard to be sure exactly how much. Second, inflation expectations look stable but cannot be taken for granted, given unease over radical fiscal and monetary policies. Third, dollar weakness and the rise in commodity prices, particularly oil, adds a new wild card to the mix.
Higher commodity prices make it less likely that headline inflation and inflation expectations will follow the underlying core rate lower in the coming quarters.
Meanwhile, there is some risk that the combination of higher oil prices and dollar weakness could unhinge inflation expectations, a scenario that could lead to an early rate rise.
Fed officials see uncertainty in the other direction too: growth could fall short of the 3 per cent to 3.5 per cent rate policymakers expect next year, raising questions of the sustainability of the upturn and leading the Fed to consider extra loans or purchases to stimulate the economy.
But as mainstream policymakers think it is possible they might have to raise rates in the next six months, they need to prepare for that, even if it is not the most likely outcome. That means revisiting the “extended period” language in the not-too-distant future.
One possibility is that the Fed might alter the phrase in a way that involves being more specific about what it means and what conditions would lead to a rate policy response.
Another is that policymakers might retain the basic structure of its guidance but progressively water it down over time, as they did in 2003 and 2004. For instance, the Fed could start by moving back from “extended period” to the original phrase “some time”. The Fed is likely to prepare the ground for a statement change through speeches or testimony first.
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