Friday, March 13, 2015

Oil Prices & The FOMC

New Monetary Policy

These are unprecedented times for monetary policy and it's compounded by abnormally low energy rates. Even if labor indicators improve and inflation remains at the 2% target, oil prices are a wild card. The FOMC may not feel comfortable raising rates until they believe:
  1. Energy rates are back to "normal" with no impact on inflation.
  2. Energy rates will remain low and there's no worry of an impending or surprise increase.
Both options require more than six months to establish a track record.

What Do FOMC Meeting Notes Tell Us

To get a better understanding for how the FOMC feels about the probability of a hike we can data mine the minutes from the last FOMC meeting. The dominant argument is to keep rates low; examples provided below:
  • Raising rates too soon could "damp the apparent solid recovery in real activity and labor market conditions, undermining progress toward the Committee's objectives of maximum employment and 2 percent inflation."
  • Raising rates too soon "would increase the likelihood that the Committee might be forced by adverse economic outcomes to return the federal funds rate to its effective lower bound." Committee members noted the "challenges associated with the prospect of commencing policy tightening at a time when inflation could be running well below 2 percent..."
  • Raising rates too soon could lead to reputation and effectiveness issues, "..the public could come to question the credibility of the Committee's 2 percent goal."
  • One person on the committee recommended "in light of the outlook for inflation, the Committee consider ways to use its tools to provide more, not less, accommodation."
Indeed, Committee members appear just as concerned about their reputation and ability to control the fed funds rate -- for more on this read the article: Can The Fed Control The Fed Funds Rate In Times Of Excess Liquidity?  -- as they are about the effect of the rate hike on the economy. Committee members are also concerned about inflation and acknowledge that it's currently being held down by large increases in energy prices. Here's an excerpt from the minutes:
Consumer price inflation moved further below the FOMC's longer-run objective of 2 percent, held down by continuing large decreases in energy prices.
It goes on to say:
The staff's outlook for economic activity over the first half of 2015 was revised up since December, in part reflecting an anticipated boost to consumer spending from declines in energy prices.
Clearly, the FOMC believes lower energy prices have contributed to lower inflation and a better economy by boosting household purchasing power, which means they believe it can also have the reverse effect if prices rebound. This volatility translates into uncertainty and it's just one of the many risks FOMC members are finding hard to digest. "Many participants," the notes said,
indicated that their assessment of the balance of risks associated with the timing of the beginning of policy normalization had inclined them toward keeping the federal funds rate at its effective lower bound for a longer time.

GAFI's Fed Funds Prediction  - 1 Yr At Least

The FOMC wants to give the appearance of being data driven and prudent so look for very specific data points like improvements in labor compensation to drive a rate increase "language", but we predict it will be at least another year before the fed actually raises rates. Not only is the FOMC worried about being about to control the fed funds rate, but the volatility in energy prices is causing FOMC participants to shy away from raising rates until they can feel reasonably sure that energy prices have stabilized. If the FOMC raises rates and inflation grows past 2% due to a rise in energy prices the decision to raise rates may be criticized which is exactly what the FOMC is afraid of.