Ben Bernanke said today that the Federal Reserve has two policy tools at its disposal: the level of the short-term interest rate and the quantity of assets added to its balance sheet. Short rates have been stuck around 0 percent for years and, according to the Fed, look to remain there until sometime in 2015. So most attention was on the impact of asset purchases and what will happen when the Fed stops buying bonds.
Yet I think that the pace of rate hikes in the coming years may prove to be the more interesting question, and the one that will be more important to the markets.
Back in December, the Fed said it would keep short rates around 0 percent as long as the unemployment rate was above 6.5 percent and the inflation rate was below 2.5 percent. Analysts have never gotten a satisfactory explanation as to how these "thresholds" would actually affect the Fed's behavior. This confusion has become increasingly relevant as unemployment has slowly sunk.
Interest rate movements since the Fed's Open Market Committee released its economic projections today suggest that markets have become relatively more optimistic about the medium-term outlook for both inflation and unemployment. While all interest rates jumped, yields on 5-year bonds (both nominal and inflation-protected) rose by about 0.2 percent -- significantly more than at any other point on the yield curve. Since the yield on any bond can be thought of as the weighted-average of future expected short-term interest rates, this movement suggests that the market reacted to the Fed's announcements by pricing in higher interest rates for 2015 to 2018.
Moreover, we have evidence from the Eurodollar futures market, which provides a pretty good proxy for market expectations of future short-term interest rates. Since the Fed forecasts were released, future expected short rates (for 2015 and afterwards) all went up by 0.2 to 0.5 percentage points.
There are a host of reasons why the markets reacted as they did. Perhaps traders focused on Bernanke's statements about inflation, or the improved unemployment forecasts, or something else entirely. Whatever the case, it's increasingly clear that traders are very sensitive to the economic outlook for 2015 to 2018 because this is what will drive the Fed's short-rate policies. This may end up being a much bigger deal than any speculation over the "tapering" of asset purchases.
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