Here's The Federal Reserve's Next Big Communication Problem

When the Federal Reserve first signaled in May that it could soon begin to slow down quantitative easing (QE) — the program whereby the Fed purchases bonds in order to loosen monetary policy — U.S. stock markets freaked out.

They have since recovered. In fact, they are red hot. The S&P 500 reached a record high 1700, and more top strategists have joined the cadre of market-watchers with a 1700-plus year-end target.

Undoubtedly, the Fed’s “forward guidance” — signaling the central bank’s disinterest in increasing interest rates any time soon — helped allay the investor fears originally stoked by the supposed “beginning of the end” of easy money.

So if QE is out and forward guidance is in, how will the Fed calm markets if it wants zero interest rates until 2016 even if other metrics, like the employment rate, near “normal” targets?

In a new note to clients, JP Morgan economist
Bruce Kasman predicts the Fed’s communication hurdle here:

In general, forward guidance has focused on the conditions for the first rate hike but the profile of policy normalization will become increasingly important. Central banks will likely find markets sympathetic to a slow movement toward the exit. But it may be more difficult to justify following a path in which policy rates remain well below pre-crisis reaction functions indefinitely. Herein lies the dynamic inconsistency of policy setting at the zero bound. The Fed will begin to face this challenge as it extends the FOMC forecasts through the end of 2016 at its next meeting. It will need to explain why
policy rates are projected to remain well below its 4% estimate of normal even as the labour market approaches the central bank’s own estimate of full employment.

Kasman titles his comment “Beyond the valley of the thresholds,” an ominous nickname for what will happen if and when labour conditions meet Fed criteria before the central bank wants to ditch its dovishness.

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