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Associated Press
Federal Reserve Chair Janet Yellen has the sensitive task of providing interest rate guidance after unemployment drops below 6.5 percent.

Yellen to set policy as threshold passes

– In her first meeting as Federal Reserve chair this week, Janet Yellen will put her stamp on policy by reaching for a favorite tool of central bankers: words intended to guide markets in the direction policymakers want.

For more than a year, the Fed has kept monetary policy easy with assurances that its main interest rate won’t rise at least as long as unemployment exceeds 6.5 percent and the outlook for inflation is no more than 2.5 percent.

That guidance is almost obsolete: while unemployment is forecast to fall below the threshold this year, most Fed officials don’t foresee a rate increase until 2015.

Yellen’s challenge is to replace the threshold with guidance that’s less specific while also making it clear that rates won’t rise any time soon.

If the Fed retreats to language that investors find vague and economic data comes in strong, traders are likely to move forward their estimate of when the central bank will raise rates, creating volatility in financial markets.

“Getting rid of the thresholds requires the committee to do something to keep the market in place,” said Laurence Meyer, a former Fed governor who is now senior managing director at forecasting firm Macroeconomic Advisers in Washington. “It is going to be quite volatile out there. What they are trying to do is prevent the markets from pushing up the timing of the rate increases.”

Volatility on interest rates of less than two years could affect borrowing costs across the economy, especially on transactions where long-term debt is financed with short-term borrowing.

The Fed’s interest-rate thresholds have helped lower financing costs for companies whose bonds are rated below investment grade, or less than Baa3 by Moody’s Investors Service or BBB by Standard & Poor’s.

Yields on speculative-grade bonds have shrunk to within 3.82 percentage points of U.S. government securities on average, down from 5.29 percentage points when the Fed put the thresholds in place on Dec. 12, 2012, according to Bank of America Merrill Lynch indexes.

Analysts at Barclays studied the market for two-year forward rates on two-year swap yields to measure the impact of expectations for changes in the Fed’s benchmark interest rate, or the overnight rate for loans between banks.

The analysis shows that volatility, or the expected size and frequency of interest-rate moves, remained low after the Fed put the thresholds in place and began to rise as unemployment fell closer to the Fed’s 6.5 percent goal.

“Less forward guidance could mean more uncertainty” about the path of the Fed’s benchmark rate, said Michael Gapen, a senior U.S. economist at Barclays in New York.

“If it is volatility because we don’t understand their reaction-function, then that is not good,” he said.

Unemployment was 6.7 percent in February, and the median forecast of economists surveyed by Bloomberg is for a decline to 6.2 percent in the fourth quarter.

Consumer prices rose 1.2 percent in January from a year earlier, according to a measure closely watched by the Fed.