Fed to Markets: Brace for Volatility

Fed to Markets: Brace for Volatility Ahead of Rate Rise, Yellen and Dudley Get Jump on Softening Landing

By Jon Hilsenrath and Brian Blackstone Nov. 7, 2014 4:47 p.m. ET 7 COMMENTS

Federal Reserve officials are warning investors and foreign central bankers to brace for market turbulence as the Fed prepares to raise short-term interest rates next year.

In a speech to central bankers Friday in Paris, Fed Chairwoman Janet Yellen said rate increases, when they materialize in advanced economies, “could lead to some heightened financial volatility.” New York Fed President William Dudley, at the same conference, issued a more detailed alert.

“This shift in policy will undoubtedly be accompanied by some degree of market turbulence,” he said of future rate increases in the U.S. “Moreover, it could create significant challenges for those emerging market economies that have been the beneficiaries of large capital inflows in recent years.”

They offered their warnings as the Labor Department released new data showing the U.S. job market is improving faster than the Fed expects. The unemployment rate, at 5.8% in October, was below the 6.3% to 6.6% range the Fed projected last December for the end of 2014. In September, the Fed revised that projection to 5.9%-6.0%, still higher than the October rate.

Other metrics being watched closely by the Fed showed continued gains. For instance, the percentage of the U.S. population that is employed rose to 59.2%, its highest level since July 2009. This employment-to-population ratio increased one percentage point from a year earlier, its largest one-year gain since March 1995.

The Fed is eyeing rate increases as unemployment declines and slack in the economy slowly diminishes. Higher rates will be aimed at preventing the economy from overheating. Many officials believe they will raise their benchmark federal funds rate from near zero by the middle of next year. Though the job market is improving more quickly than they expected, many inflation measures remain below the Fed’s 2% goal, which has given them comfort that overheating isn’t now a threat and they don’t need to rush raising rates.

“If all goes according to our forecast and the U.S. economy continues to make progress towards the Fed’s dual mandate goals of maximum sustainable employment and 2 percent inflation, the Federal Reserve will likely begin to raise its federal funds rate target off the zero lower bound sometime next year,” Mr. Dudley said.

The Fed’s initial moves away from easy money have already caused spasms in markets. Last year, as then-Chairman Ben Bernanke started talking about winding down the central bank’s bond-buying stimulus program, global stock prices fell, interest rates rose and emerging-market economies experienced outflows of capital that weakened their currencies. Early this year, as the Fed started pulling back the program, emerging-market stocks and currencies were knocked lower. Then in October, a week before the Fed ended the program, stock markets sold off and then recovered.

The Fed’s planned move away from low rates is a sign of stronger health in the world’s largest economy, good news in the U.S. and abroad. Officials see market volatility as inevitable when they start to raise rates. After years of assuring the public about low interest rates, a rate shift in the world’s largest economy will lead to new uncertainties about how quickly the Fed will move and how far. Higher interest rates tend push down stock prices and redirect investment flows that can jar currencies.

Still, with their latest warnings Fed officials are trying to minimize the upheaval by talking about it now, many months before they expect to move.

Many emerging market central banks have been preparing for this moment. For instance the Central Bank of Brazil has raised rates from 7.25% last year to 11.25% to stave off inflation and stabilize the Brazilian currency. Other emerging-market central banks, such as the Reserve Bank of India, have taken similar paths.

The watchword among many global central bankers at the Paris conference and others of late has been that they need to focus on domestic problems and prepare for international turbulence.

“In this highly connected world, you would be kindest to your neighbors when your keep your own house in order,” said Malaysian central banker Zeti Akhtar Aziz at a Bank of France conference.

—William Horobin contributed to this article.

Write to Jon Hilsenrath at [email protected] and Brian Blackstone at [email protected]