On Wednesday, the Federal Open Market Committee concludes its first policy meeting under the leadership of new Federal Reserve Chairwoman Janet Yellen.
The FOMC began winding down it's quantitative easing program of large-scale asset purchases in December, taking the monthly pace of purchases of mortgage-backed securities and U.S. Treasuries to $75 billion from $85 billion. In January, the FOMC reduced the monthly pace further to $65 billion, and of the 81 market economists polled by Bloomberg News, 78 of them expect the FOMC to make another $10 billion reduction in March.
Beyond "tapering," the next big question is what the Committee will decide with regard to its forward guidance on the likely future path of short-term interest rates.
The current guidance dictates that the FOMC will keep rates pinned near zero until "well past the time that the unemployment rate declines below 6.5%, especially if projected inflation continues to run below the Committee's 2% longer-run goal."
In recent months, as the unemployment rate has tumbled toward 6.5%, Fed officials have sought to downplay the importance of the 6.5% threshold, saying the headline unemployment rate does not sufficiently reflect the true health of the labor market, and that other indicators, such as long-term unemployment and part-time employment, offer evidence of significant slack.
Despite the already-ambiguous wording of the Committee's current guidance and recent proclamations that the 6.5% threshold doesn't really mean much anyways, the consensus view on Wall Street seems to be that the FOMC will modify the language of the guidance to stress its "qualitative" nature.
"Citi economists suggest that the language could shift to 'rate hikes are unlikely until well past the time that asset purchases are completed', the well past being a signal that a late Q3/early Q4 end to QE would have be followed by a period of several meetings before policy hikes were on the table," says Englander.
"It would be a very hawkish surprise for the Fed not to change the language of forward guidance away from the 6.5%. This would suggest that the FOMC could not find agreement on a language change, and would be viewed as suggesting as more vigorous loyal opposition."
The minutes of the most recent FOMC meeting revealed that as of the end of January, Committee members had not yet come to an agreement on how to proceed:
Participants agreed that, with the unemployment rate approaching 6-1/2 percent, it would soon be appropriate for the Committee to change its forward guidance in order to provide information about its decisions regarding the federal funds rate after that threshold was crossed. A range of views was expressed about the form that such forward guidance might take. Some participants favored quantitative guidance along the lines of the existing thresholds, while others preferred a qualitative approach that would provide additional information regarding the factors that would guide the Committee's policy decisions.
Several participants suggested that risks to financial stability should appear more explicitly in the list of factors that would guide decisions about the federal funds rate once the unemployment rate threshold is crossed, and several participants argued that the forward guidance should give greater emphasis to the Committee's willingness to keep rates low if inflation were to remain persistently below the Committee's 2 percent longer-run objective. Additional proposals included relying to a greater extent on the Summary of Economic Projections as a communications device and including in the guidance an indication of the Committee's willingness to adjust policy to lean against undesired changes in financial conditions.
Moreover, unseasonally harsh winter weather is believed to have put a damper on economic activity in the first few months of 2014, causing those betting on higher interest rates to close out their trades for now and wait until an acceleration in economic activity materializes again.
Now, with market interest rates trading in line with the FOMC's staff forecasts for the likely path of the fed funds rate, there may ultimately be little impetus for the Committee to make any changes to the language of its statement this month.
However, the FOMC will also release updated staff forecasts following this meeting, which market participants will be paying closer attention to going forward, regardless of what the Committee decides to do with forward guidance.
"The shift to qualitative guidance will put more focus on the Fed’s Summary of Economic Projections (SEP), particularly the 'dots' that reflect participants expectations for the funds rate at the end of 2015, 2016 and over the longer term," says Michelle Gerard, chief economist at RBS.
"Movements in the 'dots' will provide further insight as to how thinking among FOMC participants has evolved both with respect to the timing of the first rate hike and also the pace of tightening after lift-off. In December, the median forecasts for the year-end fed funds forecasts came down by 25 basis points in both 2015 (from 1.0% to 0.75%) and 2016 (from 2.0% to 1.75%). It is possible (though not necessarily likely at this point in time) that December's move lower could get reversed in March."
Gerard says the new SEP projections are unlikely to project an earlier or faster path of rate hikes given the recent weather-induced swoon in economic activity.
Along those lines, market participants will also be watching closely for any indication that Committee members think there is more to the recent slowdown than just transitory factors, like the weather.
The FOMC will release its decision in a statement at 2 PM ET on Wednesday afternoon. Janet Yellen's first FOMC press conference as Fed chairwoman ensues at 2:30 PM.