The FOMC expects federal funds rate to remain, for some time, below levels that are consistent with its longer run assessment. The key rational behind this idea is that for that is the neutral rate (r*) is currently low and will only move gradually towards its long term level.

Because of the headwinds: tighter underwriting standards, limited access to credit, deleveraging, contractionary fiscal policy, weak growth abroad, significant appreciation of the dollar, slower productivity and labor force growth, elevated uncertainty about economic outlook.

These have declined noticeably over the past few years, but some have remained significant. As these abate, r* should gradually move higher over time -- this can be seen in the SEP.

One indication is that growth has been only moderate despite very low level of funds rate and the large balance sheet. Had r* been higher, economic expansion would have been much more rapid.

During the October FOMC meeting the staff briefed participants about the topic and the conclusion leaned towards:

According to the Taylor rule mentioned by Yellen (Yellen's preferred Taylor rule) on her remarks earlier this year (Normalizing Monetary Policy), even considering r*=0 (the green line in the chart below) the Fed would already be behind the schedule. An r*=0 (and current readings on PCE inflation and unemployment rate) would imply fed funds approximately 50bp higher -- this is why the Fed calls the monetary policy stance accommodative (below the neutral).

The fact that the slope of the 'dots' curve is higher than the green line reflects the idea of r* gradually moving higher over time. Market forecasts, on the other hand, are betting on a secular stagnation type of story -- r* remains zero for the next two years and monetary policy stance remains a bit more accommodative as it is today (a bit more than 50bp below the r*=0 line).

The newly introduced actual in the sentence "the Committee will carefully monitor actual and expected progress toward our inflation goal" was probably key to bring the doves on board (the other was the reference to the reinvestment policy, which would continue until "normalization of the level of the federal funds rate is well under way" -- this probably helped to please Brainard).

However, the Committee was smart enough to leave this comment flexible enough to avoid tyeing the Fed to a given path of inflation. Chair Yellen ably avoided giving any hard target when questioned by reporters. They avoided the historical mistake of the 6.5% unemployment target...

The chart below gives a good picture of recent inflation performance. Both headline and core inflation were increasing at the same pace (about 1.5%) from late 2011 to mid 2014, when oil prices were roughly flat. From October 2014 to January headline inflation dropped 0.8% (-3.4% annualized) reflecting the drop in energy prices, and has increased 1.1% until last October (about 1.4% annualized). This late rebound is headline prices is roughly in tandem with the pace of core inflation.

Core CPI inflation momentum is already running 2.4% (details here) but the gap with PCE inflation has opened and core PCE momentum is in the 1.2%-1.5% range. The Fed expects PCE inflation in the 1.2% to 1.7% range in 2016 (central tendency) so the bar is not very high.

However, further decline in oil prices and/or strengthening of the dollar could easily delay Fed action.

The table below is a reference to the FOMC base case, which is compatible with "gradual adjustments in the stance of monetary policy" -- i.e., 100bp/year.

The evolution of the actual economic variables and the evolution of Fed's forecasts will tell whether the economy is ahead or behind the base case.

US trade-weighted dollar is higher than earlier in the year, when Fed warned about its negative consequences to the economy.

Oil prices are also at the lows.

Retail gasoline prices are close to the lows.

Commodity prices also at the lows.

US equities recovered part of its Aug/Sep losses, but face renewed uncertainty.

Equity vol is high again.

US 10y Treasuries

Baa spreads widened

Market-based inflation compensation sharply down, but this could just be oil prices

Financial conditions, as measured by GS, are tighter than in the last few years.

...but broadening the definition to include oil prices show a more benign picture

Financial conditions, as measured by the Chicago Fed, also show a tightening, but overall levels remain in the accommodative range

Adjusting for the business cycle, Chicago Fed index suggest that financial conditions moved to tight earlier in 2015 and are now back to easy.

Below, some additional financial conditions and financial stress indices

Longer history of financial conditions and the relevant episodes.

Minutes from the October meeting hint at an FOMC that is aiming at a dovish hike in December.

Dovish because: (a) it seems likely that they will emphasize the low equilibrium real rates as a reason for "keeping the target federal funds rate below the levels the Committee views as normal in the longer run" even after full employment and 2% inflation, and (b) it appears likely that a message will be sent that the Fed will not run out of ammunition and it would be ready to reverse course if economy unexpectedly weakens (perhaps "unconventional" policies will become "conventional"?).

The point (b) above is important because it might be what is needed for the 'doves' to be on board for voting for a hike next month.

According to the Taylor rule mentioned by Yellen on her remarks earlier this year, even considering r*=0 (the green line in the chart below) the Fed would already be behind the schedule. An r*=0 (and current readings on PCE inflation and unemployment rate) would imply fed funds at 0.75% in Sept/15 and 1% by December (based on Fed's forecasts).

This might be what Fischer had in mind when he mentioned last week that monetary policy has already responded to the dollar appreciation and foreign weakness "through deferring liftoff relative to what was expected".

Minutes confirmed my preliminary assessment after the statement and press conference: "The Fed has not materially changed the outlook, neither the balance of risks, but has acknowledged an increase in uncertainty. And if one is not willing to show this uncertainty in the forecasts, you show it by lowering the 'dots' when your forecast suggest otherwise, and sound dovish".

Despite FOMC's dovish statement and remarks, the forecasts for 2016 and 2017 have not changed materially:

Nevertheless, the 'dots' moved down by 25bp across the board. Is it compatible with the forecast revisions?

In order to check this, I have used Yellen's preferred Taylor rule -- the one she mentioned in her speech on Normalizing Monetary Policy.

The chart below plugs Fed forecasts into Yellen's Taylor rule for December 2015. It shows the implied path for interest rates assuming zero real rates (the solid light gray line) and assuming real rates at the long run value forecast by the Fed.

The lines with markers show the median and the trimmed average 'dots'. One can see that the Fed's median forecasts for interest rates at the end of 2015 have been consistent with negative real rates since mid-2013. The average in the period from Jun/13 to Jun/15 was -35bp and the most recent median dot is compatible with real rates at -65bp.

When looking at 2016 forecasts, the picture changes materially. The updated forecasts suggest nothing has materially changed in the Taylor rule range, however the median dot for December 2016 has consistently moved down since September/14. The most recent median dot is compatible with equilibrium real interest rates at -35bp.

The trend for 2017 is similar to 2016: the implied equilibrium real rate moved down by 100bp in the last year (but is currently compatible with equilibrium real rates at +50bp).

The bottom line is: no, the change in the 'dots' is not compatible with the change in forecasts (assuming the reaction function has not changed).

Therefore, the pattern of the last four FOMC dot-plots can only be compatible with the famous 'headwinds' (low oil and commodities, strong dollar, slower global growth) which, interestingly, have consistently failed to affect the forecasts. They only make their way to the underlying path of equilibrium real rates!

The chart below shows the implied Yellen Taylor rule assuming 1.5% real rate (red) and zero real rate (green). The blue dots are the median dot in the Fed's forecast and the chart shows also the fed fund futures the day before the meeting and as of September 18. Markets are skeptical the Fed will be able to follow its own plan (and markets have been right, so far).

The quick answer comes straight into the statement:

A more explicit link from global developments to domestic developments is provided in Yellen's prepared remarks at the press conference:

"My colleagues and I continue to expect that the effects of these factors on inflation will be transitory. However, the recent additional decline in oil prices and the further appreciation of the dollar mean that it will take a bit more time for these effects to fully dissipate."

In another passage of her prepared remarks, Yellen explained what has made FOMC to change stance: equity prices, stronger dollar and spreads.

Developments since our July meeting, including the drop in equity prices [-5%], the further appreciation of the dollar [2%], and a widening in risk spreads [20bp], have tightened overall financial conditions to some extent. These developments may restrain US economic activity somewhat and are likely to put further downward pressure on inflation in the near term."

So should we just focus on financial conditions? Not so fast... the Fed claims it does not target financial conditions... during Q&A Yellen stated:

"The Fed should not be responding to the ups and downs of the markets and it is certainly not our policy to do so. But when there are significant financial developments, it's incumbent on us to ask ourselves what is causing them ... And so they have concerned us in part because they take us to the global outlook and how that will affect us."

Ok. Now I got it. The FOMC has changed its global outlook and therefore its US outlook. No...read a bit further:

"...these recent developments...have not fundamentally altered our outlook. The economy has been performing well, and we expect it to continue to do so."

And then she mentions that "to be clear":

"...our decision will not hinge on any particular data release or on day-to-day movements in financial markets. Instead, the decision will depend on a wide range of economic and financial indicators and our assessment of their cumulative implications for actual and expected progress toward our objectives."

Then she added:

"The recovery from the Great Recession has advanced sufficiently far, and domestic spending appears sufficiently robust, that an argument can be made for a rise in interest rates at this time. We discussed this possibility at our meeting."

Ok. Now it is clear !! The US economy is so close to a rise in interest rates that the Committee has decided to send a very dovish message...go figure.

To be fair, Yellen mentioned that the "Committee judged appropriate to wait for more evidence...to bolster its confidence that inflation will rise to 2 percent".

It seems, thus, that despite the dovish message, the FOMC just wants to wait a bit more to make sure the recent bout of volatility will indeed only have temporary effects on the economy.

That might be the case...but it wasn't the message that came across from the statement, from Yellen's prepared remarks and from the Q&A.

The emphasis on (previously disregarded) market-based inflation compensation, explicit concerns about Chinese growth, the impact of commodity prices on emerging market economies, the capital flight from EM, and even concerns about Canada "which is an important trading partner", all departed from the message conveyed in a similar bout of uncertainty earlier this year and sounded very dovish.

Indeed, from late 2014 to earlier this year, the Fed watched a sell-off in EM currencies, a decline in oil and other commodity prices, a strengthening of the US dollar, a sharp drop in market-based measures of inflation compensation, a sharp slowdown in global trade, West Coast port slowdown, a contraction in first quarter GDP growth,..., and the message conveyed back then was more upbeat.

One thing that stood out was Yellen's remarks on inflation compensation:

"...the Committee has taken note of the recent declines in market-based measures of inflation compensation and will continue to monitor inflation developments carefully."

Back then the FOMC decided to focus on survey-based measures of inflation expectations and disregarded market-based measures of inflation compensation. In February Semiannual Monetary Policy Report to Congress Yellen mentioned that inflation compensation "mainly reflects factors other than a reduction of longer-term inflation expectations". Fed staff even prepared a box in the Monetary Policy Report explaining the "challenges in interpreting measures of longer-term inflation expectations" from financial instruments.

To be fair, when speaking by herself (and not on behalf of the Committee), Yellen often seemed more concerned about inflation compensation than the full FOMC.

Allow me a digression to show how inflation extracted from the TIPS for the 5 year period from 2020 to 2025 is correlated with today's oil prices!!

(And, by the way, market-based measures of inflation compensation today are not far away from where they were back in February 2015 when Yellen spoke to the Congress.)

Returning to the main point, it is clear that the FOMC is worried about inflation and that something has changed.

One can clearly see that in their forecasts!!

Don't you think a tenth down change in median forecast and in the central tendency range for inflation reflect a material change? Well, you've got company. It is very hard to argue that a tenth move is not well within any forecast error margin...

But, what about the move in headline PCE down from 0.7% to 0.4%? Well, that's really a large shift, but note that the core PCE rose from 1.3% to 1.4%. Moreover, would the FOMC make today's monetary policy based on the forecast for the next 3 months? Even Yellen believes monetary policy has lags..."But there are lags in the impact of monetary policy on the economy" she answered in the Q&A.

So, if the FOMC has not materially changed the forecasts, has the dovish message resulted from a change in the balance of risks? The statement reads:

"The Committee continues to see the risks to the outlook for economic activity and labor market as nearly balanced but is monitoring developments abroad."

It seems the risks remain balanced but worth monitoring; so has uncertainty increased?

Yellen mentioned in the prepared remarks that "the outlook abroad appears to have become more uncertain of late, and heightened concerns about growth in China and other emerging market economies have led to notable volatility in financial markets".

So it seems that an increase in uncertainty was behind the change to a more dovish stance. But what is odd is that this uncertainty is not reflected in the forecasts. Look at GDP, unemployment and inflation forecast in the table above: forecast ranges have not changed materially from June -- this does not reflect an increase in uncertainty (or the Fed was not brave enough to change forecasts and acknowledge the worsening of the outlook and increased uncertainty).

So, the Fed has not materially changed the outlook, neither the balance of risks, but has acknowledged an increase in uncertainty. And if one is not willing to show this uncertainty in the forecasts, you show it by lowering the 'dots' when your forecasts suggest otherwise, and sounding dovish.

One of the key arguments against an increase in fed funds on September 17th is the fact that the Fed has not provided a 'heads-up' and therefore the market is not prepared for it. It would be too disruptive to move away from the ZLB without the markets being prepared for it, the argument goes.

The immediate answer is yes -- just look at the fed fund futures and you'll see that the probability of leaving the zero bound is as low as 30%. The Fed only moved in the last 20 years when the implied probability is north of 70%, Larry Summers recently said.

But looking at economist surveys, one gets a different picture. A Bloomberg survey shows that 51 out of 113 economists / strategists expect the Fed to move 25bp on Sept. 17th and 3 expect a move half this size. A similar survey by the FT shows 47% of 30 economists expect a move.

One may quickly dismiss surveys and argue that market prices provide a more accurate picture.

So, let's take a closer look at market prices other than Fed funds futures.

The term structure of the yield curve provides valuable information. From 1985 to 2007, 99% of the variance of the term structure of the yield curve can be explained by two factors (the first 2 PCA).

The chart below shows that using the common information provided in the 6m, 1y, 2y, 3y, 5y, 7y, 10y, 20y, and 30y constant maturity treasuries one can closely replicate the actual Fed funds rate. Note that the PCA calculated does not include the FF.

So it is clear that the term structure contains information on the fed funds rate. Note also how the blue line (FF compatible with the term structure) often (but not always) anticipates the move in the actual fed funds.

What if we use the model coefficients estimated up to 2007 (to avoid including the period of the crisis) to forecast where the fed funds rate should have settled, based only on the actual path of the yield curve term structure? (again, not using the actual fed funds).

The chart below shows that the estimated fed funds would have been negative for most of the ZLB period. Except for the last few months!

Zooming into the ZLB period, one can see that the term structure of the yield curve is compatible with a fed funds rate which has increased since Jan/2014 and matched the actual fed funds by November 2014.

The most recent data shows that the term structure is compatible with fed funds at about 35bp, exactly where the market expects the FF to trade after the first hike!

Bottom line: the term structure of the yield curve already embeds one hike.

US trade-weighted dollar is higher than earlier in the year, when Fed warned about its negative consequences to the economy

Oil prices are also back to the lows of earlier this year

Retail gasoline prices are not at the lows but have trended down since July

Commodity prices have just made new lows

US equities are 7% down since mid August

Equity vol off the highs but still elevated

US 10y Treasuries

Baa spreads widened materially vs Aaa

Market-based inflation compensation sharply down, but this could just be oil prices

Financial conditions, as measured by GS, have already tightened sharply in 2015...

...but broadening the definition to include oil prices show a more benign picture

Financial conditions, as measured by the Chicago Fed, also show a tightening, but overall levels remain in the accommodative range

Adjusting for the business cycle, Chicago Fed index suggest that financial conditions moved to tight since the beginning of 2015

Below, some additional financial conditions and financial stress indices