Markets Freaked Out over Two Words Janet Yellen Said Today, Here’s Why

by Patrick Brennan

The Federal Reserve Open Market Committee announced its latest statement of policy Wednesday, and markets seem to have found the policy announced tighter — less stimulative — than expected, because stocks and bond prices fell substantially, though this moderated by the end of the day. The Fed was expected to slow its QE3 bond-buying program again, to $55 billion a month, as it did.

Yellen also suggested that the Fed might raise interest rates “six months” after QE3 ends — and that’s exactly when markets freaked out. Why?

The Fed announced today that it had discarded what was called the “Evans Rule,” which promised that interest rates would remain around 0 until the unemployment rate hit 6.5 percent, at which point the Fed would become more worried about sparking inflation. The problem: Unemployment has now dropped to 6.7 percent, and the Fed hadn’t been planning to raise rates anytime soon and doesn’t think it should.

So now the policy-making body, the Open Market Committee, ditched the Evans Rule and will rely on a more subjective explanation of how the labor market and inflation will drive policy.

It’s the following:

In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress — both realized and expected — toward its objectives of maximum employment and 2 percent inflation.

This is obviously not nearly as clear as an actual rule, however subjective that was too. When do committee members think employment will be good enough, and inflation risks serious enough, to justify raising rates from 0? We already knew, roughly. The Fed releases the following chart, which shows when committee members think they should, based on the Fed’s economic projections, raise rates from 0:

A more detailed version is here, using dots to show where each committee member thinks rates should be over the next three years.

Except then Yellen said that (understandably) those “dots will move up and down,” since the economy and the labor market won’t necessarily move exactly as the committee members predict. Employment projections from the Fed have improved recently — partly because they believe weather has depressed current job growth — so reporters wanted to hear from Yellen when she thought the first rate hike would come, especially since 2015 isn’t very precise.

That’s when she uttered the two words that sent the Dow off a 200-point cliff: “Six months.”

That’s her guess for the “considerable time” she thinks should be left between the end of quantitative easing, scheduled to end this fall, and the first increase in interest rates. It puts rate hikes earlier in 2015, a bit sooner than people expected — hence, stock-market pain and bond-market drama.

But Yellen has plenty of time to reconsider that off-the-cuff suggestion, and has huge amounts of discretion in her statements to adjust to changing economic conditions. I wouldn’t ascribe much policy significance to it — which is not to say that it’s clear she or the whole committee actually has a clearer or better path in mind, as I explain over at the Agenda.