The Fed tool that is having a powerful impact

Unlock the Editor’s Digest for free

Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is a former Federal Reserve economist, founder of Sahm Consulting and a writer of the Stay-at-Home Macro blog

In the past month, there has been a significant shift in the views of investors on where interest rates are heading. The yield on 10-year US Treasury notes jumped half a percentage point, before a sharp retracing this week. High rates boost the borrowing costs for households and businesses. And that adds to the big increases in the past two years.

The increase in market rates is seemingly at odds with the Fed’s decision at its late-September meeting to hold the federal funds rate, its policy interest rate, steady. In a recent interview, Austan Goolsbee, president of the Federal Reserve Bank of New York, said the recent rise in long-term interest rates was a “puzzle” and downplayed the Fed’s role.

Goolsbee is partly correct. Several other factors, such as concerns over rising federal deficits, which increase the supply of Treasuries, could be pushing up interest rates. And there’s no consensus on the cause. However, Treasury yields rose somewhat directly following the Federal Open Market Committee policy-setting meeting in September, and there are reasons to think that the Fed caused that increase, even if unintentionally. If unintentional, that is particularly a concern given the rising risks of the central bank raising rates too high at this stage in the cycle.

What the Fed said about the future, known as “forward guidance”, probably made a difference. At the last meeting, officials updated their expectations for economic growth, unemployment, inflation, and, most importantly, the federal funds rate for the end of this year and the next three years. It’s known as the Summary of Economic Projections and is a collection of individual forecasts from the 19 Fed officials. Unlike the changes in the federal funds rate, which committee members vote on, the SEP is uncoordinated and anonymous.

The idea of the SEP and other tools of forward guidance, like the press conference and speeches, is to influence borrowing costs for firms and households now by signalling to financial markets what the Fed may do. It was created at the end of the Great Recession brought on by the global financial crisis.

Then the benchmark federal funds rate was at zero, which left little scope to push down borrowing costs and boost economic activity. Even though interest rates now are well above zero, the Fed uses it to bolster its credibility as an inflation fighter and give markets a heads-up on what future policy might be. Forward-looking markets build that into market asset prices now.   

The SEP is a powerful tool. Economists Taeyoung Doh and Andrew Foerster at the Federal Reserve Bank of Kansas City argue that the SEP and other types of forward guidance shorten the time it takes for the Fed to affect financial market conditions and the economy.

However, the SEP can also be an unpredictable tool. What the Fed thinks it is saying (in words or numbers) and what market participants hear are not always the same; it can take time to line the two up. Thus, small changes in the SEP sometimes have outsized effects on interest rates as markets catch up. It looks like that might have happened after its last meeting.

So what did the SEP say? The Fed sees a more robust economy and higher interest rates than its last SEP in June. The median forecast across Fed officials for inflation downplayed the recent good news on core inflation and passed none of that unexpected disinflation through to the coming years. In contrast, the SEP marked gross domestic product up and the unemployment rate down throughout.

The Fed’s usual good-news-is-bad-news style raised its path for the federal funds rate next year, strengthening its “higher for longer” mantra. It’s not hard to see how that would boost market interest rates; fewer rate cuts expected from the Fed were a surprise after months of disinflation.

The SEP often gets pulled into bigger debates. One example now is if a recession is coming. Some called the SEP a “Goldilocks” forecast because it looked like inflation would come down and unemployment would stay low, but Fed chair Jay Powell at the press conference disputed that such a “soft landing” was the Fed’s baseline expectation. When the SEP and the chair don’t send the same message, it’s confusing but not unusual.

Another debate is whether we have entered a persistently higher interest rate world. The Fed did not raise its estimate of the long-run federal funds rate, but it stretched out the current levels and allowed the inflation-adjusted rate to move up further. So it’s at least a thumb on the scale that the Fed is in no hurry to lower its interest rate.