FOMC Wrap: Another Policy Shock :Nomura

Chairman Bernanke and the Federal Open Market Committee (FOMC) delivered
another policy "shock" today. They provided an optimistic assessment of the economic
outlook and much greater clarity on their plans for policy.
Although the policy details were broadly in line with our forecast, we did not expect the
Committee to be so explicit in laying out its plans at this time. We were also surprised
that it did not acknowledge the current “soft patch” in the economic data or the recent
tightening of financial conditions.
The net effect is that there appears to be a stronger consensus within the FOMC for
beginning the process of removing accommodation than we expected. The strong
market reaction to the FOMC statement and the Chairman's press conference is, in
our view, consistent with this judgment.
FOMC plans for policy
The Chairman said that if the economy evolves as the FOMC expects – i.e. if growth
picks up in coming quarters, if labor market performance continues to improve and if
inflation expectations remain well anchored – then it expects policy to evolve in the
following way:
 The FOMC expects to take its first step to reduce the pace of asset
purchases later this year.
 The FOMC also expects to end asset purchases around the middle of next
year, when it expects the unemployment rate to be around 7%.
 The FOMC expects to raise short-term interest rate for the first time in the
first half of 2015.
The FOMC‟s statement also noted that downside risks had diminished since the fall,
suggesting a higher degree of confidence in its positive outlook for the economy and
labor markets.
Ironically, this proposed path for policy is consistent with our pre-meeting forecast, but
we did not expect the Chairman, with the Committee‟s support, to lay out a plan at this
time. We thought the Committee would take more time to reach consensus and that it
would move more cautiously in light of the slowdown in activity in the second quarter
and the recent volatility in financial markets.
The net effect is that the FOMC appears to be further along in the process of
deciding to scale back asset purchases – and more generally beginning the
long-term process of “normalizing” policy – than was evident before today.
FOMC Forecasts
The FOMC participants‟ forecasts suggest that they have an optimistic outlook for the
economy. The central tendency for growth was revised down somewhat for 2013, but
their forecasts remain notably above those of the market participants. The central
tendency of FOMC participants appears to expect growth of 2.5-3.0% in the second
half of this year (Nomura: 2.2%). FOMC participants also revised up their forecasts for
GDP growth next year (Figure 1).
In addition, the FOMC revised down its forecasts for the unemployment rate across
the whole path. These revisions suggest that FOMC participants have changed
their views on some key fundamental trends, such as productivity growth and
labor force participation in a way that suggest it will take less growth than
previously assumed to generate a tightening of labor markets.
Forecasts for inflation in 2013 were revised down substantially, but the revision to the
forecasts for 2014 and 2015 were much more modest, suggesting that the Committee
expects inflation to pick up back towards its 2% target.

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Financial conditions
The FOMC statement did not mention the recent tightening of financial conditions. In
fact, Chairman Bernanke argued that financial conditions are still supportive of growth.
This suggests that the FOMC does not believe that recent changes to financial asset
prices pose a material threat to the economic recovery. We agree that financial
conditions are still supportive, but are surprised, however, that the FOMC's
expectations for the economy and policy were not more sensitive to this concern,
particularly in light of recent market volatility. We will have to see whether or not the
FOMC's optimistic forecast for the second half of the year proves to be consistent with
the tightening of financial conditions we have experienced in recent weeks.
Concerns about Inflation
The recent declines in headline and core PCE inflation to around 1% y-o-y and sharp
declines in inflation breakevens had raised questions about whether or not concerns
about excessively low inflation would affect the FOMC debate. President Bullard of the
Federal Reserve Bank of St Louis had expressed this concern most forcefully in the
run up to the meeting. It appears that the rest of the FOMC does not share these
concerns, or at least not to the same degree. Bullard actually dissented from the
FOMC decision citing the concern that the Committee was not showing strongly
enough its “willingness to defend its inflation goal.” We are somewhat surprised that
his views are so far out of the mainstream that it resulted in a dissent.
Asset purchases and forward guidance
The Chairman reiterated a number of times the distinction between asset purchases
and the FOMC forward guidance on interest rates. He also noted that an
unemployment rate of 6.5% was a threshold for raising short-term rates, not a trigger.
That is, the FOMC has said it will not raise interest rates before the unemployment
rate falls below 6.5% (or the outlook for inflation goes above 2.5%). But that does not
mean they will raise the federal funds rates as soon as the unemployment rate falls to
that level.

That said, the median of the forecasts of FOMC participants for interest rates at the
end of 2015 actually increased from 50 to 100 basis points. Thus the FOMC's
message about the likely path of short-term interest rates was not uniformly
dovish.
Exit strategy
The Chairman noted that the Committee continued to discuss its exit strategy and it
may at some point provide more new information on how its thinking evolved. In the
meantime, the Committee's previous “exit strategy,” which was originally
presented in June 2011, remains in effect, with one exception. The Chairman
noted that most FOMC participants believe that the FOMC is unlikely to ever sell
any of its holding of MBS.
Communication
The FOMC was surprisingly forthcoming in a number of ways. Most importantly,
Chairman Bernanke laid out the Committee‟s expectations for how policy will evolve,
assuming its economic forecast proves accurate. This plan (outlined above) clarifies
the timing of the wind-down of asset purchases and the initial decision to raise interest
rates. He also noted that they expect the unemployment rate to be around 7% when
ending asset purchases, thereby providing some type of guideline for how labor
market development will drive asset purchases.
It was also an innovative in having the Chairman lay out the plan for policy in a
press conference. The minutes to this meeting, which will be released on 10 July,
should provide more information on the degree of consensus on the Committee for
this plan.
The bottom line
Today we have a better sense of where the FOMC is going. Greater clarity about
policy should, over time, help to reduce volatility. But the content of the
message delivered today is that the FOMC is further along in its thinking about
“normalizing” the stance of monetary policy than we had anticipated.