FOMC: Fed on Hold Till Mid-2014

• The Fed surprised the market by announcing that rates are expected to be exceptionally low at least through late 2014 - almost three years from now! This was one year later than we expected. However, exceptionally low does not necessarily mean unchanged rates, as 11 out of 18 members see the rate higher than the current rate in late 2014. This was a bit of a surprise.
• There is a wide dispersion between Fed members' estimates of the first hike with three members wanting a rate hike already in 2012 while two members want to wait until 2016.
• The Fed also announced a new explicit longer-run goal on inflation at 2%. This is slightly higher than the previous longer-run projection of inflation at 1.75%-2% that was part of the economic projections, but not stated as explicit goal.
• Despite the recent improvement in the economy the Fed is still very cautious on the outlook in the statement. The Fed sees modest growth in the coming quarters and still significant downside risks to the outlook. The Fed also gave the inflation outlook a dovish twist by removing the sentence that it will pay close attention to inflation and inflation expectations
• The more dovish statement may be due to a change in voting rights with three hawks no longer being voters and only replaced by one hawk, Jeffrey Lacker, who dissented. The projections reveal a more hawkish tilt among non-voters.
• Based on the new FOMC projections, we now look for the first rate hike in mid-2014 (instead of late 2013).

The Fed's new forecast

First hike: The Fed in its statement now sees exceptionally low rates at least through late 2014. This is on the surface very dovish. However, the members' projections revealed a high degree of dispersion, with three expecting a rate increase in 2012, three in 2013, five in 2014, four in 2015 and two in 2016. This leaves a less dovish picture than the statement. At the press conference, Bernanke said he suggested to use the median of estimates. The median in Q4 14 is 0.75% - see link to projections.

Hiking pace: Only six out of the 18 members see rates unchanged through the end of 2014. This indicates that exceptionally low rates is not equal to unchanged rates but rather at or below 1% as 11 members have this projection.

The Fed has now given itself a new tool to keep long-term yields low without increasing its balance. Instead of buying bonds to get longer yields down, it is now keeping yields low by predicting to keep rates low for a very long time. On the one hand, this seems smart as they do not have to print more money. On the other hand, it can backfire if it turns out they end up raising rates earlier than predicted. Then this weapon would not be credible in the future.

The statement

Growth: The growth section is broadly unchanged. Only added a "further" in front of improvement in overall labour market indicators. Changed description of outlook for growth to modest from moderate pace. The Fed still expects unemployment to decline only gradually towards the level consistent with its' mandate. The Fed also continues to see "significant downside risks to the economic outlook" due to financial strains. Again, a bit dovish given the recent improvement in indicators.

Inflation: The Fed gave the inflation part a clearly dovish twist. Inflation is now described as having "been subdued in recent months" instead of "moderated". The Fed has also skipped the sentence ""However, the Committee will keep close attention to the evolution of inflation and inflation expectations", a sentence that has been there for a long time

Policy: The Fed moved up the paragraph on the policy outlook and changed the timing of how long rates are likely to stay at exceptionally low levels to "at least through late 2014" from "through mid-2013". The Fed kept the paragraph on asset purchases unchanged and repeated that it will regularly review the size and composition of its security holdings and is prepared to adjust those holdings as appropriate. Hence the Fed is keeping the door open for more QE if necessary.

Dissenters: Jeffrey Lacker dissented. He got voting rights in 2012. The three hawks who have previously voted against easing (Narayana Kocherlakota, Charles Plosser and Richard Fisher) are no longer voters. In addition to Lacker, new voters are Sandra Pianalto, John Williams and Dennis Lockhart - more centrist/dovish voters.

Assessment and outlook

It is not totally clear what the Fed means by exceptionally low level of Fed funds rate now given that 11 out of 17 members see the Fed funds rate higher than the current rate by late 2014. So far, the interpretation would have been to see exceptionally low rates as unchanged rates. But now it may seem that it means below 1% or lower.

On the back of this, we now see the first rate hike in mid-2014, moved from our previous estimate of late 2013.\