A Fed phrase change could mean rate hikes sooner

Odds are rising that the Federal Reserve could make an important change to its policy statement at its meeting next week, and markets could see it as a cue that rate hikes are coming sooner than they expect.

The change being debated is whether to drop the phrase that says there will be a "considerable time" from the end of the Fed's bond purchases, or quantitative easing, to the first rate hike. "Considerable time" has generally been interpreted to mean at least six months, or four meetings. With QE set to end in October, the language is a big reason that markets have pegged next summer as the most likely time for the first rate hike from the Fed in eight years.

Now, both hawks and doves on the committee have taken to criticizing "date-based forward guidance" by the Fed, saying it should follow the economy, not the clock.

Philadelphia Fed President Charles Plosser, a hawk on the committee who dissented at the last meeting over concern with the considerable time language, said over the weekend: "Our first task is to change the language in a way that allows for liftoff sooner than many now anticipate, and sooner than suggested by our current guidance."

Janet Yellen, chair of the U.S. Federal Reserve.
Andrew Harrer | Bloomberg | Getty Images
Janet Yellen, chair of the U.S. Federal Reserve.

But Boston Fed President Eric Rosengren, a leading dove on the Federal Open Market Committee who sounds in no hurry to raise rates, said, "We should be moving away from providing date-based forward guidance, and instead focus on what incoming data tell us about reaching full employment and 2 percent inflation within a reasonable time period."

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That has prompted Fed observers on Wall Street to raise the odds that change is coming next week. "The desire to get away from date-based guidance appeals to both hawks and doves," JP Morgan Chase's Chief U.S. Economist Michael Feroli said in a report. "We view the chance of such a change next week as close to 50-50." Previously, most observers saw little chance of a change.

Former New York Fed official Krishna Guha, now at ISI, said he believes "considerable time" survives the September meeting but "we view this as a much closer call than we did a week ago." Guha still thinks the change is more likely at the October or December meetings.

The market impact will depend on how it's interpreted, as a way to raise rates sooner, as a way to give the Fed more flexibility to raise rates, or as a way to lessen risk in the market. Plosser seems more interested in the change to push his view that rates should be higher. Practically, the Fed could not raise rates while that language remains.

Rosengren seems to support the move more because he thinks the market is not incorporating enough uncertainty around the outlook for Fed policy.

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Wrightson ICAP's Lou Crandall suggests it is the market's very benign outlook for Fed policy in the coming year that could prompt the Fed to act. The December 2015 Fed Funds futures suggests the rate will the end the year at just 75 basis points. The average of the Fed's own forecasts for 2015 would put the rate at 1.2 percent. A recent San Francisco Fed research paper puzzled over the gap between the Fed's and the market's rate outlooks.

"They could be motivated to make the change because of the gap between what the Fed forecasts and where the market is," said Crandall, who also said the odds are higher that a change could be made. But he's still on the fence.

Such a change could also introduce greater volatility into interest rates and thereby equities. Each economic report will be scrutinized more closely for the impact on the date for interest-rate liftoff. The Fed could welcome such volatility as it would lessen the downside for markets of a change to interest rates once it really comes.

—By CNBC's Steve Liesman.