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Federal Open Market Committee - Another Headache for the Fed?

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Fed Changes Tact in Forward Guidance
The first Federal Open Market Committee (FOMC) meeting under Janet Yellen’s leadership brought a much anticipated format change in communication policy, as well as a widely discounted $10bn reduction in monthly asset purchases. There was also abolition of the so-called Evans Rule, which allowed some overshooting of the Fed’s 2% long-term inflation target. Despite the new Fed Chair trying her utmost to portray the policy outlook as dovish, financial markets were not entirely convinced. Altering forward guidance was always going to be the biggest challenge in 2014, particularly given the faster-than-anticipated decline in unemployment. Policy thresholds have been abolished.
The emphasis of forward
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Unfortunately, the increased importance of policy language has increased the scope for misinterpretation, as well as ambiguity. A hawkish view of future Fed policy can be taken from the decision to abolish the Evans Rule, named after the President of the Chicago Fed. This formed the bedrock of the policy thresholds. The Evans Rule was designed to tell markets that policy rate settings would not change until certain economic conditions were satisfied. Consistent with its dual mandate, the FOMC announced policy thresholds covering both unemployment and inflation. The unemployment threshold (6.5%) always dominated the inflation equivalent (2.5%), even though the Fed never had an explicit long-term target rate for unemployment. In contrast, the Fed has a long-term inflation target of 2%. Under the Evans Rule, given that the threshold was above the target, there was scope for inflation to overshoot. The abolition of the Evans Rule and the policy thresholds now means that the 2% inflation target effectively becomes the ceiling. The importance of inflation in setting the policy rate has increased: low interest rates will only prevail if inflation remains below 2%. This potentially marks an important shift in the Fed’s thinking on the trade-off between unemployment and inflation. Previously, Fed Chair Yellen believed the costs of overshooting the inflation target were lower than those associated with elevated unemployment.
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