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Net Net: Promoting innovation and managing change

The Federal Reserve is making a major shift in interest rate policy

Fed to stay lower for ... ever?

The Federal Reserve may go from moving the goal posts to removing them altogether when it comes to setting interest rate expectations.

Those goal posts have come in the form of economic numbers—more specifically, 6 percent unemployment and 2 percent inflation—that, if hit, would trigger interest rate increases.

But many central bank watchers agree that the use of those targets—part of "forward guidance," in Fed parlance—is reaching an end. Chair Janet Yellen tipped her hand after the last Fed Open Market Committee meeting, and market participants believe the use of the unemployment and inflation targets is about to go away for good.

Instead, the Fed is likely now to rely increasingly on the more-nebulous "data dependent" terminology for when it will lift its target funds rate off the floor, and won't wed itself to the specific targets first delineated in 2012.

Janet Yellen
Andrew Harrer | Bloomberg | Getty Images

"The need for timely flexibility and data-dependent discretion would make the committee's lock step adherence to an obsolete forward guidance policy unwise," Bob Eisenbeis, chief monetary economist at Cumberland Advisors, said in an analysis posted on the SNL Financial site. "In effect, what we have seen is the rational abandonment of forward guidance as a useful policy tool in favor of discretion."

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For investors, the ramifications are a Fed that likely will be more flexible and able to retreat from its historically unprecedented level of cheap money at its discretion rather than being dictated to by arbitrary economic benchmarks.

The central bank has resisted raising rates even though unemployment has fallen below the original 6.5 percent target and as internal questions have been raised over whether risk assets like some areas of the stock market and high-yield bonds have become overpriced.

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Under the new approach, the Fed will not be dictated by a specific data set or two but rather by the larger economic picture.

Eisenbeis pointed specifically to the Fed back in March already dropping its specific unemployment rate target, replacing it instead with "maximum employment." He also cited statements from Yellen after the September meeting that interest rate decisions would be data-driven, as opposed to the "considerable time" language that intimated the central bank had a calendar date for when it would raise rates.

"In effect, she repudiated the 'considerable time' language in the statement, validating (Philadelphia Fed President Charles) Plosser's concern and effectively adopting his approach," he said. "The result is effectively to eviscerate meaningful forward guidance, since we now don't know how data-dependent the committee's views will be."

Yellen is "not going to be locked into some artificial number someone picked before her," said Jim Paulsen, chief market strategist at Wells Capital Management. "It was ridiculous to begin with, and it's good they do away with it."

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The move away from forward guidance appears to be a victory for Fed Vice Chair Stanley Fischer, who has sided with critics who believe the approach is dangerous and actually could lead to the central bank having communication problems if, as is the case now, the Fed doesn't follow through on raising rates once the targets have been hit.

Though they are otherwise close ideologically, adherence to forward guidance has been considered a key difference between Yellen and Fischer.

The balance of the FOMC joins them, though, in a generally dovish approach to interest rates that will only be exacerbated in 2015 when Dallas Fed President Richard Fisher and Plosser leave the Fed. Both are reliably hawkish, but their exits give President Barack Obama an opportunity to appoint yet another Fed official in favor of keeping rates lower for longer.

Removing forward guidance as an essential policy tool effectively gives the Fed more room to stay dovish regardless of what headline employment and inflation figures say.

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"Before Obama gets done here you could have one of the most dovish Feds there's been in a long time," Paulsen said.

Investors will get a better look at the central bank's thinking after the October meeting, when the FOMC is expected to end the monthly bond-buying program but keep rates anchored.

"It will be interesting to see whether the FOMC's new communications task force addresses the forward guidance issue head on or whether it devises instead a strategy that pretends that forward guidance is still in play," Eisenbeis said. "Nevertheless, for those rational policymakers who value discretion, forward guidance is dead!"