Institutional fixed-income money managers generally welcomed the Federal Reserve's earlier-than-expected decision in December to tie interest rates to specific economic indicators, with some concern for the possibility of greater volatility.
Concluding their last 2012 Federal Open Market Committee meeting on Dec. 12, Federal Reserve officials committed to further bond purchases and to keeping the federal funds rate within a zero to 0.25% target range “at least as long as the unemployment rate remains above 6.5%.” The shift from calendar-based guidance that had rates staying at zero to 0.25% through 2015, to specific thresholds such as a change in unemployment, “is a better form of communication,” Chairman Ben Bernanke said at a news conference.
“The date-based guidance served a purpose, but was not a transparent process,” he said, whereas with threshold-based guidance, “the markets and business community can make the adjustment on their own. It will allow the markets to respond quickly.”
But that response to certain economic indicators, like a change in the unemployment rate, as a trigger for interest rate changes can also create a greater risk that investors will react to more volatile data points, and in the process create more market disruption than the economy as a whole might warrant. In recent years, unemployment rates, for example, moved up for a few months, and then sat unchanged for six months, even though other economic indicators improved.
“As the economic data come out now, the market is going extrapolate those short-term fluctuations. It could create opportunities, but there is a possible impact as well,” said Robert Tipp, Newark, N.J.-based managing director and chief investment strategist at Prudential Fixed Income, which ran $356 billion as of Sept. 30. “If they come out with hard criteria, that will inject a lot of volatility into the market.”
John Bellows, investment management strategy analyst with Western Asset Management in Pasadena, Calif., which runs $459.7 billion, is not concerned. “Volatility could increase, but perhaps not by as much as some fear. The Fed went out of its way to say that these aren't hard targets. I think the Fed is going to try very hard to preserve flexibility and they won't respond to any one data release. They are not obligated to act” if the unemployment rate drops below 6.5%.
“They are definitely not targets,” agreed Joshua Feinman, New York-based managing director and chief global economist for Deutsche Bank Asset Management in the Americas, which managed $26.3 billion in fixed income as of Dec. 31, 2011. “They are thresholds for the Fed to begin considering changing the funds rate. They want to give themselves wiggle room to respond. No single variable can capture all the complexities and nuances of the U.S. economy. They have to lift up the hood and see what's really going on.”