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 Catching investors off guard is the last thing U.S. central bankers
want to do, which helps explain their repeated recent warnings over
complacency in financial markets, and Fed Chair Janet Yellen's
pointed comments this week about banks and others building up
dangerous "interest rate risk."
Yet many Wall Street economists, skeptical that the economy will
finally break out of its recessionary funk, do not believe the Fed
will tighten its extraordinarily easy monetary policy as soon or as
aggressively as its forecasts suggest, surveys consistently show.
U.S. bond markets also have shown little sign of prepping for a rate
hike. Meanwhile most Fed policymakers have been surprised by the
sharp drop in unemployment and pleased by signs that inflation is
firming. They are wrapping up an asset-purchase program and starting
to detail exactly how they plan to raise rates from near zero.
"I don't think people have really internalized how rapid the decline
(in unemployment) has been," St. Louis Fed President James Bullard
said in an interview.
If strong jobs growth continues, and if economic growth bounces back
from a decline in the first quarter, "there will be a lot more talk
about an earlier date of possible liftoff."
Bullard has warned that the Fed is now closer to its inflation and
unemployment goals than at any time in about a decade. Hawkish
relative to most colleagues at the Fed, he wants to see a rate rise
in the first quarter of next year, about four months ahead of the
market. And he is not alone: on Wednesday, Richard Fisher of the
Dallas Fed said rate hikes are "likely" early next year.
"There can be volatility in markets, and sometimes there is kind of
a realization that an existing view is not panning out ... and there
is a sudden adjustment in markets," Bullard told Reuters. "One of
the good things about talking about the economy every day and
reassessing the data every day is you get that process to be more
gradual."
Based on futures trading at the CME, investors have been fixated for
most of the year on July 2015 for a small rise in the key federal
funds rate. The chance of a March rate rise, in their view, has
hovered around 20 percent.
While Fed policymakers generally expect rates to have risen to
1-1.25 percent by the end of next year, primary dealers surveyed by
the New York Fed last month pegged it at only about 0.63 percent by
that time.
"We know from the past that economic recoveries come quick and
furious," said William Larkin, fixed income portfolio manager at
Massachusetts-based Cabot Money Management, which manages $500
million. He said he is repositioning for more economic strength,
with the yield on the 10-year rising to about 3 percent in the next
few months from about 2.5 percent now. "When this unwinds, it's
going to hurt investors," he said.
ON THE SAME PAGE
The Fed's nightmare is a recurrence of last spring, when U.S.
mortgages and other borrowing costs shot up after then-Chairman Ben
Bernanke talked about the prospect of reducing bond purchases "in
coming meetings."
The so-called taper tantrum also slammed emerging markets as
investors priced in an earlier tightening cycle, compelling several
of Bernanke's colleagues at the Fed to walk back the importance of
his comment. But the damage to the economy, and the central bank's
reputation, was done.
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This time, Yellen, whose reputation will hinge on how smoothly she
can reverse the world's biggest-ever experiment with monetary
stimulus, wants investors and the Fed to be on the same page as the
first U.S. rate hike since 2006 approaches.
"We are attentive to risks that can develop in this environment,"
she told a Senate committee on Tuesday, "and when interest rates
ultimately begin to rise, that if firms or individuals have taken
risks and aren't prepared to deal with them that can cause
distress."
Yellen stressed the current continuing need for accommodation and
said policy would respond to the economy, as usual.
But she subtly shifted her tone, saying that the Fed could raise
rates sooner "if the labor market continues to improve more quickly
than anticipated." In June, she sounded more tentative, promising
faster rate hikes "if the economy proves to be stronger than
anticipated."
HEADING TOWARD GOALS
Indeed, U.S. employment looks better now than most policymakers or
economists had expected.
The unemployment rate fell to near a six-year low of 6.1 percent in
June and payrolls jumped by 288,000, having averaged 231,000 per
month this year. The report prompted JPMorgan and Goldman Sachs to
shift forward their predictions of the first Fed rate rise, but even
those top banks don't see it happening until the third quarter of
next year.
To be sure, some officials say the Fed can and should keep rates low
even if the labor market continues its upward climb, so long as
inflation looks set to stay around target. That's the view of
Chicago Fed President Charles Evans and Minneapolis Fed President
Narayana Kocherlakota, who said last week that "no one's going to be
criticizing us if employment gets too high ... as long as inflation
is too low."
Caution is also being preached from abroad.
IMF Managing Director Christine Lagarde has not been shy to
recommend that the Fed only gradually raise rates, often citing the
taper tantrum as the example to be avoided for the harm it brought
on the stocks and currencies of countries such as India, Turkey and
Argentina.
But the Fed's remit is the U.S. economy, where inflation is slowly
edging higher.
Even though the main gauge watched by the central bank continues to
run below its 2 percent target, in the 12 months through June the
key measure of U.S. producer prices increased 1.9 percent after
having risen 2.0 percent in May.
And while growth sharply contracted in the first quarter, hurting
prospects for the full year, by law the Fed aims for stable prices
and maximum sustainable employment.
"Growth is not part of the Fed's objectives," Cornerstone Macro
partner Roberto Perli wrote in a note. "If potential growth is
lower, the Fed will achieve its goals with lower growth."
(Reporting by Jonathan Spicer and Ann Saphir; Editing by Ken Wills)
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