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Crescenzi: Fed Conditions Its Commitment on Rates

I said in a note on Tuesdaythat the best way for the Federal Reserve to smoothly exit from its current stance on monetary policy is to make it more a process than an event, in particular by conditioning any change in the commitment on rates to economic and financial conditions. The Federal Reserve today conditioned its commitmenton rates, by adding in three conditions that will determine the future course of monetary policy:

“The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

In citing these three conditions, the Federal Reserve has provided a roadmap by which market participants can gauge with greater precision the evolution of monetary policy, in particular the exit strategy for the Fed’s current stance.

The roadmap will guide market participants to react incrementally and in process-like fashion to incoming data and financial conditions rather than react suddenly to either the Fed’s policy statements or speeches and comments by Federal Reserve officials delivered during the inter-meeting period. This will make the implementation of the Fed’s exit strategy more a process than event. It will also give the Fed an “out” because incoming data related to the three conditions mentioned will take on greater weight than the Fed’s own words, allowing the Fed to simply rubberstamp the conclusions drawn by market participants regarding the incoming data.

By making conditional any changes to its policy commitment, the timeline for future Fed policy changes is left unchanged, which should also smooth the market response.

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The Fed on the whole retained its more upbeat assessment on economic growth, increasing it a bit compared to the assessment contained in the September 23rd policy statement.

This is apparent in the first sentence, where the Fed said that activity "continued to pick up," and in the statement on household spending, which was characterized as "expanding," rather than improved further.

Even the housing market was given a thumbs up, despite weaker data of late. Here the Fed simply took the long view, saying activity had increased "over recent months," underscoring the idea that the Fed wanted to convey a message of confidence over the economic outlook.

Inflation

The Fed is either extremely confident on the inflation front or relying upon it having made conditional its commitment on rates to keep a lid on inflation expectations, because there was no change in the Fed’s statement about inflation:

“With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.”

It is intriguing that the Fed would label inflation expectations “stable” when the amount of inflation expectations embedded in 10-year inflation-protected Treasuries reached its highest point of the year—2.14%, indicating that 10-year inflation-protected Treasuries (TIPS) are priced for the consumer price index to increase at a 2.14% rate over the next 10 years. Moreover, other barometers widely used by market participants to gauge inflation expectations have been signaling increases in inflation expectations, including gold, and the value of the U.S. dollar.

Today TIPS, gold, and the dollar are front and center with respect to the three conditions that Fed has put forward. Next up will be jobless claims and non-farm payrolls. Market responses to the “resource utilization” condition will now increase.

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Tony Crescenzi is Senior VP, Strategist, Portfolio Manager Pimco. Crescenzi makes regular appearances on financial television stations such as CNBC and Bloomberg, and is frequently quoted across the news media. He is also the author of "Investing from the Top Down," "The Strategic Bond Investor," and co-author of the 1200-page book "The Money Market."