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Fed now expected to stay lower for a lot longer

The Federal Reserve building.
Andrew Harrer | Bloomberg | Getty Images

Remember when the Federal Reserve was going to raise rates next spring? Yeah, well that was fun while it lasted.

After multiple mini-panics that the U.S. central bank was ready to tighten sooner than expected, market experts have begun to resign themselves to a Fed prepared to stay lower for longer—perhaps much longer.

Declining oil prices have led to a belief that inflation remains tepid, while global growth is relatively anemic. Even though the labor market continues to show signs of improvement, the Fed likely will use the low inflation expectations as fuel to stay dovish when it comes to its target funds rate, which has been stuck near zero for more than six years.

In its 2015 outlook, LPL Financial expressed optimism for U.S. economic growth, believing that gross domestic product could increase at a better than 3 percent annualized pace for the first time since the end of the Great Recession.

Yet economic indicators that the Fed utilizes, particularly those that look at unemployment, show enough slack to justify, along with low inflation, continued ultra-easy monetary policy.

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"Although most metrics have partially recovered from their Great Recession lows, only a few have returned to 'normal.' Until they do —or at least until they make significant progress toward normal—markets should expect that the Fed will be content with keeping its fed funds rate target near zero," LPL said in its annual look-ahead report for clients. "In our view, the Fed is not likely to begin raising rates until late 2015, or possibly early 2016."

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Despite the consistently dovish language that has come out of Fed statements, market participants have been on edge over whether the central bank might produce a shock move at some point, particularly if the unemployment rate continues its descent. One area of concern is the so-called dot plot—a chart showing individual members' rate expectations that suggests increases faster than priced in fed fund futures bets.

Wall Street threw the infamous "taper tantrum" in May 2013 after then-Fed Chair Ben Bernanke made comments intimating that the Open Market Committee was getting set to end quantitative easing and begin raising rates shortly after.

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In March 2014, at her first news conference as Fed chair, Janet Yellen rattled the market with comments interpreted as meaning the Fed would raise rates within six months of ending QE, which would have put the first hike around March 2015.

Though QE, which refers to the Fed's monthly bond-buying program, ended in October, expectations are dimming that it could foretell a rise in rates anytime soon.

Citigroup, in a recent analysis for clients, scaled back its outlook for rates based in large part on the expected economic reasons many have cited. However, Citi experts also see the Fed walking a tightrope between not being seen as beholden to markets but also not set to do anything to disturb the financial ecosystem.

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Ultimately, the analysis reasoned, the Fed would err on the side of continued easing.

"We have changed our Fed call given the preponderance of downside risks," the analysis from William Lee and other economists said. "We have pushed back our forecast of the time for the first policy rate increase to the December 2015 FOMC meeting, and have moderated the pace of rate increases."

A darker analysis of Fed motives comes from banking analyst Dick Bove, vice president of equity research at Rafferty Capital Markets.

Bove believes the Fed not only won't raise rates—but also actually can't hike due to what he calls a central bank "black swan" scenario.

Increases in the money supply and a recovering U.S. economy may make the Fed want to tighten. Reality, Bove said, will step in.

"If the Federal Reserve were to raise interest rates it would cause the dollar to rise even more sharply in value. This would harm the U.S. trade balance causing the deficit to rise even more sharply," he said in a note. "This would slow domestic economic growth and cause unemployment to rise. Thus, the Fed cannot act no matter what it wishes. This is something that the policymakers may never have considered. It is now their black swan."

The "black swan" reference is to something improbable but highly significant. Fed critics have been warning for years that it could find itself in a box when it failed to tighten earlier, with an unexpected rise in inflation that forced a faster, sharper series of rate increases the biggest risk.

During the time of extreme Fed easing, inflation stayed low due in large part to the reserves it created and used to buy bonds largely lying fallow in bank coffers.

Much of that time period saw the Fed take the lead among global central banks, easing in terms far greater than any of its counterparts. That dynamic has changed, with Japan in aggressive QE and the European Central Bank expected to launch its own version soon. Bove sees a "currency war" developing that will put the Fed in an uncomfortable position.

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"Now, the game is changing. In the past three months the banks have been pulling money out of the Federal Reserve," Bove said. "They reduced reserves by $234 billion in this period. This money is now in a position where it can be loaned and increase money supply which has grown by $122 billion in this past three months. Therefore, the growth in money supply may accelerate increasing the risk of higher inflation."

Therein is the Fed's "black swan," he added.

"The likelihood is that the agency will avoid tampering with employment and let inflation expand," Bove said. "The reason is that it is no longer free to do what it wants as long as the currency wars are underway."