The markets are pricing in the Fed's first rate hike late in the second quarter of 2015 (see chart). Investors' rationale seems to be as follows:
- QE is expected to end in October.
- The FOMC's recent statements say that the rate hike will come "considerable time" after the end of QE.
- "Considerable time" is interpreted to mean at least six months (4 FOMC meetings).
- This puts us somewhere into June of 2015.
The markets' interpretation of "considerable time" however contains too much certainty about the timing of "liftoff", which until recently had resulted in declining volatility across asset classes. If you know the Fed's timing too precisely, you can value assets with higher precision as well, thus reducing volatility. That certainty has been making the FOMC uneasy. Janet Yellen spoke about it back in June.
Janet Yellen (June 18, 2014): - ... it is important, as I emphasized in my opening statement, for market participants to recognize that there is uncertainty about what the path of interest rates — short-term rates — will be. And that’s necessary because there’s uncertainty about what the path of the economy will be. And I want to emphasize, as I have, that the FOMC will adjust policy to what it actually sees unfolding in the economy over time, and that necessarily gives rise to a certain level of uncertainty about what the path of rates will be. And it is important for market participants to factor that into their decisionmaking.
Recently the FOMC has been attacking this interpretation by the markets, especially since the implied timing of liftoff does not match the FOMC's own forecast. In particular some members have been criticizing the so-called "date-based forward guidance", with preference for language that has a closer link to US economic performance. For example Fed's Charles Plosser and Eric Rosengren have both expressed concern about this "date-based" approach. This preference to change the language had the effect of increasing market volatility (by reducing the certainty of timing) in recent weeks (see chart) as well as raising short-term rates.
The question that a number of Fed watchers are trying to answer now is whether the FOMC will remove the words "considerable time" from their statement this week (or later in the year). That simple change in the language could be the key driver of volatility across global markets in the nearterm.
We are going to invite the readers to answer this question via the Quibblo polling system that shows results in real time.