Guidance for mid-2015 Policy Move to Provide Stability
A small risk remains for disinflationary pressures. However, the scale is tilted so marginally at present that it should tip toward excess growth and inflationary pressures at anytime. The oil shock which shall be transitory will not have a lasting grip on inflation. In fact, the lower oil prices today may in a short time serve to boost inflation expectations again as generally rising energy prices equate to rising inflation expectations.
I shall keep the discussion about specific changes to policy prescription for this meeting to a minimum (see bullet points below) as I believe a strong majority have a good handle on that outcome. Instead, we will review the nature of volatility as it relates to shifts in monetary policy paths from accommodative to less accommodating.
Regular readers here will remember that we have advanced the notion that the Fed would not discard the ‘considerable time’ language until it was rendered meaningless and throwing off an odor similar to that from a long dead rodent under a back deck.
It is not so much that a policy rate move is necessarily so nearby that renders ‘considerable time’ less useful – though such a move is nearby. Instead, rather than providing economic agents additional confidence in the form of a longer period of knowable policy path as it once did, ‘considerable time’ has become a distraction to economic growth in that it attracts attention to the uncertainty surrounding the shifting policy stance.
Consider briefly the four monetary policy transitions during a regular policy cycle: Easy to Neutral, Neutral to Tighter, Tight to Neutral and finally Neutral to Easing. The transition from Easy to Neutral (accommodative to less accommodative) monetary policy is the part of the Fed cycle that affords the most risk. Said differently, this is the part of the Fed’s policy cycle that rightly requires the most data dependency. Especially at the zero-bound, the Fed wants to get the timing right. An aborted policy transition here could prompt a long period of policy uncertainty and result, all else equal, in lower levels of risk assumption and viable productivity investment.
‘Considerable time’ language fails to provide any stability as regards an understanding of the likely policy path and thus is expected to be removed at the December meeting. ‘Considerable time’ was rendered nearly useless following the addendum attached at the last FOMC meeting noting that a policy response could come either sooner or later should data unexpectedly shifts in either direction.
We had come to expect that the nearness to a policy shift, still expected in mid-2015 would create more volatile markets and we have seen as much in equities, interest rates and commodities, most particularly oil of late. The VIX index sports a 50 day moving average that is higher than any since January 2013 at 15.8. The Move (Merrill Lynch 1-month Implied Treasury Volatility Index) 50 day moving average is higher than any since December of last year. These indexes help to demonstrate the heightened uncertainty surrounding upcoming but still less definitive monetary policy shift.
Market calm generally experienced over the last few years has allowed households and business to repair their balance sheets, even though thus far there has been less than hoped for consumer spending and business investment. Market calm was brought about in part by the strong conviction economic agents had in their clear understanding of where short term rates would be over a longer timeframe. Greater calm induced by policy path certainty brought about a stronger economic response than seen earlier in the financial crisis.
The point of policy flux from increasing to decreasing levels of accommodation is now near enough that the visibility or confidence level surrounding expectations for policy path and available liquidity have diminishes. This tempers an overall willingness to assume risk. As such, pockets where an abundance of investment was earlier directed can be found extended and subject to liquidity constraints.
This may be helpful in understanding the current oil shock and repercussions for other markets. Attractive borrowing rates and extraordinary liquidity may have prompted a greater than currently sustainable flow of funds toward shale oil discovery, extraction and transportation. This condition, like housing in the mid-2000’s reached beyond the physical markets and into credit standards and types of financial instruments used to finance such operations. As long as the underlying asset, then housing and today arguably oil, were expected to command stable to growing prices, the willingness of lenders to make funds available was strong.
One might argue that the housing bubble of mid-2000’s and today’s oil shock are entirely different in that the housing bubble happened during a period where the Fed was removing accommodation, whereas today the Fed has held policy rates near zero for 6 years. How can the repercussions of excessive leverage and malinvestment in the housing market a decade ago compare with the investment in energy production and today’s oil shock? Does this mean that the Fed cannot proceed with accommodation removal because the recovery has been jeopardized by a well articulated policy rate path over the last 6 years?
To the first question, we might recognize that the housing bubble and subsequent dislocation as well as what some are now calling the shale bubble were both born out of very predictable Fed monetary policy regimes (paths). It is not so important that policy rates in 2004-2006 were higher than rates today. Instead, we should concentrate on the fact that the path for policy rates was as predictable then as they have been for some time now. It is not so much that rates are today near zero, as that moving them prompts dislocation. Near zero policy rates were once predictable across a great swath of the policy path timeline and are no longer as knowable. Then as now, the confidence held by economic agents in their understanding of the path for policy rates became diminished. Currently the debate rages about when the Fed will first raise the policy rate and by how much that rate will rise through time.
In contrast, when the Fed in 2006 chose to discontinue the path toward successive, marginal and completely telegraphed 25 basis point policy rate increases, it short-circuited a most dependable policy path. Economic agents had so relied on the nature and predictability of that policy path that the longstanding time lag between policy initiative and the effects felt on the economy had become grossly stretched. By the time the Fed exited the policy path of 25 basis points, per meeting of policy rate firming, the build-up of malinvestment was great. The snapback from an elongated time lag between policy initiative and its effects on the economy was extreme. All at once, the effect of those marginal rate increases came to bear on the economy. Forestalled by the nature of policy guidance, the absence of that guidance compressed that lagged effect.
Today, the Fed is moving closer to changing policy. The Fed is rightly becoming more confident in the need for a policy shift not because of excessive malinvestment and accompanying systematic risk, though there is a healthy concern and attention focused in that direction. Instead, a majority of Fed officials have become increasingly confident that the economy shows strong enough signs of stable growth that the slack in resource allocation will further diminish. The urgency felt for this course of action toward higher rates is tempered by only slow and uneven increase in inflation thus far.
The predictability of the Fed policy rate path had until recently been very clear for years. The Fed told us as far back as September 2012 at the FOMC meeting that policy rates were likely to remain low until at least mid-2015. At that same meeting they introduced ‘considerable time’ to describe a period for which a highly accommodative monetary policy stance would be appropriate following the strengthening of the economic recovery. They have consistently used this phrase since. This guidance has of course offered, until recently, a strong confidence in the likely path for policy rates.
Mid-2015 is the most widely expected launch date for policy initiative more than 2 years later. Economic agents found that policy rate timeline understanding very supportive and it gave them a greater willingness to take on risk. Were it not for a wide output gap and rolling concerns that the economy might slip back into a recession, these economic agents would have been more aggressive in their assumption of risk to take advantage of this condition.
There were of course some areas where economic agents were sufficiently incentivized to make use of the understanding of steady state policy rates for a ‘considerable time’. As a case in point, extraction costs of $60-$70 a barrel for shale oil, give or take $10 or so depending on a multitude of factors, against a price range of $75-115 since 2011 along with a confidence that the Fed would keep rates low until at least mid-2015 was incentive enough for many to get involved.
Today, only 6 months away from mid-2015, economic agents are comically becoming more greatly aware that the path for policy rates is not sufficiently predictable. They can rely on generally low rates over the coming year, but they cannot be as certain about the path for rates as they had been earlier this year. This in large part is why oil fell as much as it did, why spreads between Treasuries and high yield securities have widened and why equity and commodity markets more generally have been volatile.
It is much easier to invest for the long term when one has great confidence in their understanding of financing costs or ‘hurdle rate’ for next two years. This is what a path for policy rates can bring. Whether those rates are steady, steadily declining or steadily increasing, a known path for policy rates is extremely supportive of economic activity when a large enough output gap exists and an agent for malinvestment when the gap is marginal.
When I was a boy scout I went to a camp that allowed us to shoot skeet with a buckshot 22. I had limited success initially until I recognized that if I waited for the clay pigeon to break either right or left, I could more easily predict the path and place the shot in its expected path. Right now, with respect to fed guidance, the pigeon is launched but it hasn’t broke in either direction; so we sit on our hands waiting for the break.
The risk that extreme malinvestement, cause by extraordinary confidence in a known policy path over the last 5 years had of course been greatly tempered by the size of the output gap that existed. The Fed is completely correct in providing all measures of support for economic growth during times of distress which create wide and unwanted gaps between economic potential and current conditions. As those gaps disappear, the need for and danger in providing assurances in policy path for rates becomes greater.
As the Fed moves from more to less accommodation provided, it will at least initially want to maintain as high a level of predictability about the policy rate and the use of other policy tools as possible. In doing so, it will continue to provide support through communication and understandings for policy path which will soften the unavoidable uncertainty economic agents have around the policy shift.
What the Fed should do eventually and where they got it wrong in the mid-2000’s, is to reduce guidance as the economy improves. This may appear to some as irresponsible Fed behavior but it is not. If high levels of monetary policy transparency are to accompany strong economic growth near full employment and minimal resource slack, the Fed will have to raise policy rates significantly more to counterbalance the support that policy transparency provides. The Fed can begin to withdrawal some measure of active support through reducing policy guidance as economic agents gain confidence about sustainability strong economic conditions. In effect, the support provided by a knowable policy path can be replaced by confidence in economic conditions.
Compared to the mid-2000’s, the Fed will have reason other than the level of rates to pare back its support through communications. For a protracted period forthcoming, the risk for higher long term Treasury rates as economic progress is achieved is reduced by the lack of supply and Fed holdings of these securities. Upward pressure on long term rates from rising term premium as a result of increased volatility in short term rates will be countered in part by the downward pressure on rates from the stock effect of the Fed’s portfolio.
The Fed Understands the Significance of Policy Path
At a recent luncheon meeting on Monday December 8th, Atlanta Fed President Lockhart noted the danger in making the path for policy rates less easy to read. With regard to the danger of ‘reversing a start to interest-rate normalization’ Lockhart indicated; ‘There would be real costs associated with an irresolute path of policy.’ More important than the concern Lockhart expressed for lost Fed’s creditability as the result of an aborted policy firming would be the disruption cause by a less understood Fed policy path. Fed creditability aside, a break from a strongly anticipated path for policy rates from the zero bound would do damage to the level of risk economic agent would be willing to take for some time.
The best way to avoid having to break an expected policy path from the zero bound is to postpone that adjustment until greater assurances can be made that a rate hike will not need to be reversed. This is essentially the argument that Chicago Fed Evans has been making. We should expect Fed officials are well aware of these conditions on the approach of policy rate lift-off and expect they will have waited sufficiently long enough to be reasonably sure they will avoid having to reverse a policy initiative. There is a growing level of confidence both inside and outside the Fed that mid-2015 will allow sufficient time to recognize the stability and sustainability of economic growth.
Pain in the form of higher volatility from increased levels of uncertainty surrounding a policy change from accommodation add to accommodation removal is already weighing upon the markets. Following through with a longstanding expectation for an initial policy rate move in mid-2015 is the least painful way through current uncertainty. On the other side of the first policy rate hike, where expectations for pace and duration of accommodation removal reside, another elongated period for understanding policy path waits. The Fed would do well to get to the other side of the first policy move and return to heightened levels of certainty about the path for policy rates. In doing so, the Fed will be closing the door on policy uncertainty and likely opening a huge can of ‘animal spirits’.
An initiation of accommodation removal starting next year is clearly expected and largely supported by Fed officials in general. Any artificial vagueness about likely policy firming plan could damage Fed creditability and add volatility to markets. If the Fed is predictable about the process of shifting from accommodative to a less accommodating policy stance, the potential level of market dislocation can be reduced.
The clearest way to reduce dislocation at this point is to remove ‘considerable time’ and replace it with a reference about a willingness to be ‘patient’ in attending to accommodation removal as was done in 2004. Economic agents know that script and that familiarity will lend stability to markets.
A Thought for Tomorrow: Term Premium and Long Rates Then and Now
In 2004-2006 the reduction in short-term interest rate variance expected and realized around the policy rate path brought about extreme pressure on the term premium, helping to keep longer dated rates lower than they would otherwise have been. If the stock effect of the Fed’s portfolio is expected to maintain downward pressure on long rates, the Fed might be required either to raise policy rates more quickly for a given level of sustainable growth above potential or reduce the level of supportive guidance about the path for policy rates. The former would be expected and the latter would indicate lessons learned from the 2004-2006 ‘measured pace’ disaster.
So as not to appear uncaring about details of policy prescription provided at this meeting, I would offer the following bullet points:
- The Fed drops ‘considerable time’ and replaces with ‘patience’
- The statement strengthens language about economic and job growth
- Oil price declines are noted and recognized for having only transitory impact on inflation
- Continued reinvestment of maturing securities and principal payments with no additional guidance given as yet
- SEP dots roughly unchanged – possible small shift lower in fed funds rate projection 2015
- SEP – small up-tic to real GDP ’15 and ’16
- SEP – small down-tic to unemployment rate ’15 and ‘16
- Q&E – Yellen to acknowledge some comfort and confidence in being able to move forward with policy shift
As an Aside: If someone wants to buy a used pick-up truck today, he would not look in Chicago where gasoline prices are suddenly lower, he looks in North Dakota where gasoline prices are suddenly lower, but also are the number of help wanted signs.