High FOMC Turnover Makes For Mixed Messages

end of 2017. If instead, the dovish view were to prevail, it would be critical for the Fed to defend the credibility of its “lower for longer” message.

Those skeptical of forward guidance would most likely prefer the Fed to communicate to markets a policy rule closer to a Taylor rule with some discretion, rather than a policy rule based on strong forward guidance. Therefore, the key issue ahead will be whether Yellen can convince the rest of the FOMC to maintain the “lower for longer” forward guidance approach. While the median FOMC voter currently adheres to the Yellen view, the situation may change for several reasons:

The less dovish members may push to de-emphasize forward guidance and the SEP dots;
As uncertainty recedes about the end-2016 outlook for inflation and labor-market conditions, the policy reaction function of the median FOMC voter may change: that median FOMC voter may decide that a near-0% real fed funds rate is too low and would thus choose to front-load the policy rate normalization process toward 3% by the end of 2016;
Concerns about asset bubbles and financial stability may induce FOMC members to consider using monetary policy to control bubbles, especially if macro-pru policies fail to contain current and future frothiness in financial markets. While Yellen is wary of using monetary policy (policy rates) to control bubbles, other FOMC members are more open to this option if macro-pru policies prove insufficient.

Therefore, for the FOMC to make its multi-indicator-based forward guidance approach work, we believe that the members will need to follow Yellen’s lead and make a stronger and more cohesive effort to communicate the FOMC’s policies and views on the economy. If Yellen continues to communicate in this manner, and is able to rally the overall signaling of the Fed’s stance around her views, then the Fed may be able to temper the headwinds generated by the current absence of a more explicit policy framework. If not, we would be concerned that a somewhat less dovish FOMC membership may have an impact on the market’s perception of the timing and speed of the Fed’s policy normalization and the degree to which the Fed will continue with forward guidance in the future. Certainly, the Fed is now in the middle of a serious debate on the nature of its policy reaction function once policy rates start to rise above 0%. The result of this debate will be key to assessing whether the pace of policy normalization currently priced in by markets – that is, close to the Fed’s SEP dots – is correct or not.

The Known Knowns

Although the market will have to adjust to a number of new Fed officials over the next year, the FOMC’s 2014 and 2015 cohorts contain a number of familiar figures. Below is a summary of their current views on how monetary policy should evolve over the next few years.

New York Fed President William Dudley is a dove and a core member of the FOMC. In aspeech on May 20, Dudley did not add color on the timing of the first rate hike, but noted that the pace of tightening thereafter “will probably be relatively slow.” Dudley expects that the fed funds rate consistent with a 2% rate of long-run personal consumer expenditure (PCE) inflation is likely to be well below the 4.25% historical average that accompanied 2% inflation. (With respect to the labor market, Dudley noted that he believes a much greater proportion of long-term unemployment is the product of cyclical forces.) Dudley is likely to align with Yellen in pressing to keep rates “lower for longer.”

San Francisco Fed President John C. Williams will be a 2015 voting member, and therefore likely to play a role in the forward guidance debate in 2015. In a May 22speech, Williams noted that “a real tightening of policy – which would mean raising the fed funds rate – is still a good way off.” Although Williams is dovish, he is a mild dove at best and may have views diverging from the “lower for longer” pledge; for instance, Williams had seemed to be leaning in the direction of an expeditious retreat from QE last spring.

Dovish Atlanta Fed President Dennis Lockhart will be a voting member in 2015 and is likely to support “lower for longer” forward guidance. In a May 11 speech, Lockhart said that the first rate hike would likely come in H2 2015, stating that “When the first move to tighten policy is taken, I would expect it to begin a cycle of gradually rising rates.” Lockhart sees both a shortfall from potential and below-objective inflation as justifying patience in raising policy rates.

Chicago Fed President Charles Evans is markedly dovish and a clear proponent of forward guidance. As a 2015 FOMC voting member, he will be strongly in favor of maintaining forward guidance to shore up the recovery. In an April 9 speech, Evans observed that “It certainly seems that the fallout from the financial crisis and persistent headwinds holding back economic activity are consistent with the equilibrium real interest rate being lower than usual today.” In Evans’ view, the FOMC’s March “lower for longer” pledge accounts for the possibility of lower real rates.

Richmond Fed President Jeffrey Lacker is generally hawkish, although he has not spoken recently regarding the Fed’s March communication changes on interest rates. He votes in 2015, and may lean against the forward guidance pledge.

Philadelphia Fed President Charles Plosser is a hawk and a member of the FOMC in 2014. In a May 20 speech, Plosser said that “as we continue to move closer to our 2% inflation goal and the labor market improves, we must be prepared to adjust policy appropriately. That may well require us to begin raising interest rates sooner rather than later.” Plosser’s next voting term is in 2017, however, and therefore he will influence the debate (rather than the vote) on “lower for longer.”

Minneapolis Fed president Narayana Kocherlakota, a 2014 voting member, is a hawk turned noted dove. In a May 21 speech, Kocherlakota stated that he currently saw the Fed as undershooting both its price stability and maximum employment mandates. Kocherlakota’s next voting term is also 2017 and therefore, like Plosser, he will influence the debate rather than the vote on “lower for longer.”

Finally, there is Dallas Fed President Richard Fisher, who is currently a member of the FOMC and also a noted hawk. Fisher has never been a proponent of QE, long arguing that Fed asset purchases can lead to excessive risk taking and the creation of market bubbles. As Fisher rotates off the Committee this year and will not be a voting member again until 2017, his views will have less bearing on the timing and pace of rate hikes over the next couple of years.