Yellen's Fed and the end of cheap cash
In her first meeting, the new Fed chair Janet Yellen continued the trimming of cash injections or quantitative easing (QE) that started under her predecessor Ben Bernanke but made her own mark in other ways. Namely, it's clearer than before when the era of cheap cash is likely to end (this year at this pace), when interest rates will rise (about six months after the end of QE) and that the new normal interest rate for the US will be lower than before (projected at 4%).
Firstly, the Fed's cash injections will be cut back at the same pace by another $10bn, taking the total to $55bn in the third trim down from the initial $85bn. This was widely expected as Yellen probably didn't want to surprise markets if economic conditions were not markedly different than when she was Bernanke's deputy when the policy of the so-called tapering was proposed last May and begun last December.
But, Yellen abandoned the unemployment target that had been the key target of forward guidance that was to guide expectations as to when rates will go up. Like the Bank of England (BOE), the Fed has now scrapped the target of 6.5% as the unemployment rate has dropped to 6.7%. Instead, forward guidance will depend on a number of factors, such as labour market conditions, how large the gap is between potential and actual output, etc.
In other words, what central bankers had always looked towards but was considered too vague to shape expectations and therefore the Fed and BOE had opted for a clear unemployment target. But, now we're back to what central banks had always done, which is to make a judgement based on a number of factors that point to how the economy is faring. At least Yellen acknowledged why unemployment, though important, isn't working as a guide.
As I've written about before, the Fed, unlike the BOE, publishes the forecasts of individual members of the rate-setting committee so that it is still more transparent when the first rate rise could come and that information is what a number of analysts in the market tell me that they rely on more than "forward guidance" in whatever form.
Based on those individual projections, the US economy looks to be in better shape than before. US interest rates are forecast to rise to 1% by the end of next year, which will require three rate hikes over the course of the Fed's 8 meetings in 2015. The prior set of projections took rates to 0.75% by the end of next year and 2016 now sees rates at 2.25% versus 1.75% by year end.
Yellen also revealed that although it was hard to quantify, there would probably be "around the order of six months" between the end of QE and the first rate rise. As the current pace of cutting back $10bn per meeting, QE will end by this year, so the first rate hike could come by next spring/summer.
If rates rise, then that would mean that the US economy is headed back toward normal times when rates are not at the abnormal level of 0%. The Fed's projections also show that unemployment will fall below 6% within two years, heading toward the 5% that had been the long-term unemployment rate before the financial crisis.
The Fed also thinks that even if the economy and unemployment get back to normal, the new interest rate will be below the long-run average for the US and is projected at 4%. That is likely to reflect an economy that is more averse to growth driven by credit so will need lower rates to boost investment and consumer spending.
These are key bits of information that matter for firms and households — the time between the end of QE and rate hikes and what the new interest rate is after the stimulus ends — that Yellen's Fed has articulated to help guide the economy.
These go a long way toward increasing transparency which central banks need in order to manage what are called inflation expectations. Those expectations, formed by markets, help translate what the Fed says into the rates that banks and others offer as mortgage or business loans.
In other words, the Fed under Janet Yellen is already - usefully — clearer than before.