Quarterly and Orderly
The Federal Reserve is getting ready to deliver another modest measure of policy accommodation removal following its upcoming March 14-15 FOMC meeting. A year separated the first two policy adjustments and until recently, it was widely believed that an additional half year would expire before the Fed came again with a rate change. Instead, economic data continues to point toward growth nearing or exceeding potential and inflation approaching the Feds 2% stated goal. The current Federal Reserve policy path prescription is getting an update that I am calling ‘Quarterly and Orderly’ – an increasingly anticipated and highly visible series of 25 basis point rate hikes at each of the next 4-6 quarterly FOMC meetings.
For now we expect the Fed to increase the fed funds policy rate by 25 basis points per quarterly meeting in a ‘scheduled’ application of monetary policy measures. It has been a long time since the Fed has been willing to run somewhat on ‘autopilot’. Not since early-2006 has the Fed had sufficient confidence in the lasting nature of economic growth to allow for such a ‘hands-off’ approach. The Fed will continue to advise that the stance of monetary policy will be directed by the unfolding of economic, financial and global market conditions. However, they will also emphasize that the nature of economic growth allows for a more steady policy application over the intermediate term. Despite somewhat uncertain conditions in domestic politics, the Fed appears ready to set a path for policy rates that is not entirely unlike its approach in the 2004-2006 ‘measured pace’ experiment.
The benefits from this change in policy application come primarily in two forms. First, moving forward with increases in fed funds may give the Fed additional policy optionality down the road, leading to greater longer run stability when, as is inevitable, economic growth returns to a slower pace. Additionally, a visible, predictable and widely understood fed policy path provides a level of confidence that both encourages risk taking and promotes lower levels of term premium.
Greater levels of risk assumption is the expected outgrowth of a steady, widely understood and relied upon pattern of policy accommodation removal, particularly but not exclusively when started from a level of low real policy rates. These same conditions bring about a further delay in the lagged response of the reaction function for the timing of downward pressure on economic growth expected from higher policy rates.
Term premiums are also pressured lower as a result of a visible, though restrictive policy path because the incremental, path dependent, monetary policy application reduces the variability of short term rates around its projected path; thus providing greater confidence in forecasts for longer term Treasury rates. That greater confidence in long-term rate projection reduces the hurdle rate for many capital projects, thus having the potential to improve longer term growth prospects.
The prospects for economic growth have improved beyond that witnessed in modestly better economic reports of the last months. In particular, we see the likely change in monetary policy direction as a near term benefit to economic growth as the Federal Reserve moves from a ‘data dependent’ mantra to a ‘path dependent’ form of policy implementation. The benefits from an exaggerated lag time between application of policy restraint and its economic impact along with downward pressure on term premiums from the assumed reduced variability about the path for short rates will be evidenced in greater risk taking over the near term. This will provide additional assurance for increased economic growth that may eventually require a more determined application of policy accommodation removal.
The latest Summary of Economic Projections from the December 2016 FOMC meeting indicated the participants median expectations for a 2017 year end Federal funds rate was 1.4%, or 3 applications of 25 basis point rate hikes this year. Only a few weeks ago, it was widely believed that the Fed would not be willing or able to achieve that level of accommodation removal before year’s end. Instead, the market had priced closer to only 2 small rate hikes. There are roughly 3 rate hikes now priced for 2017 and as indicated earlier, I expect there to be 4 hikes; one at each quarterly meeting.
By year’s end, the Fed should be fairly well along its way toward normalizing the policy rate if the longer run equilibrium level of fed funds remains at 3%. The Fed has indicated regularly for some time that it will not adjust its balance sheet of securities held ‘until normalization of the level of the federal funds rate is well under way’. Fed funds are expected to be roughly 1.66% by year end which will imply a little more than half way toward the 3%, movable longer run equilibrium and will likely justify the initiation of balance sheet drawdown.
The Fed is expected begin the process of eliminating the reinvestment of maturing securities at the start of 2018, with an announcement likely at the December FOMC meeting indicating a steady and predictable pace that is clearly articulated. This approach, much like the clearly articulated program for the tapering of securities purchases initiated in January 2014 (announced December 2013 FOMC meeting) will add an additional measure of predictability to monetary policy intentions. And so while essentially a means of reducing the level of accommodation, the process of drawing down the reinvestment of securities in a discrete and widely understood format will promote additional visibility and therefore give modest encouragement to risk taking.
The Fed is currently expected to raise policy rates on Wednesday and follow with equal 25 basis point measures over the next 3-5 succeeding quarterly meetings. It will essentially be returning to a ‘path dependent’ policy directive from the present ‘data dependent’ policy directive. In providing a highly visible policy path, it is expected the Fed will induce some additional response in the form of a greater appetite for risk taking. Together with an exaggerated lag time for policy action to be felt in the economy and the benefit from lower term premium, a case can be made for a consistent overshoot of the productive capacity of the economy. This could prolong the application of a ‘path dependent’ policy directive.
The initiation of balance sheet reduction is not expected to begin until early-2018, with an announcement late this year. The process of reducing and eliminating the reinvestment of maturing securities will be well articulated and easily modeled so that while the stock of securities will shrink only very slowly, the application of the reduction of securities held will offer additional visibility to monetary policy proceedings. The net effect of the shrinking balance sheet will therefore be minimal for the foreseeable future.
A highly visible monetary policy path offers benefit in the form of increased risk appetite until the level of economic output is exceeded to the extent malinvestement prevails. Before this point is reached it is likely advantageous for the longer run benefit of the economy for the Federal Reserve to reduce the level of monetary policy visibility.