Wednesday, June 15, 2016

FOMC Report June 14-15, 2016; Gradual is as Gradual Does



The gradual pace for ‘normalizing’ monetary policy Fed officials have since December indicated as appropriate is only one meeting away from becoming a dated concept and unsuitable.  As relates to monetary policy, gradualism implies at least some movement.  For most, a pace recognized as gradual would include some policy movement at a minimum roughly semi-annually.  Therefore, a next-move in policy rates further afield than July would not really be suitably termed gradual. 

A policy move later than July, if connected at all to the December initial policy rate hike suggests the pace of normalization be more appropriately termed ‘sluggish’ or ‘unhurried’, if not ‘ad hoc’.  The time lapse between policy rate moves at this juncture is no small matter and is not easily dismissed. 

It has been a long time since economic agents were afforded any meaningful guidance from the Fed which might reduce uncertainty surrounding monetary policy.  Not since the Fed finished tapering securities purchases have economic agents had helpful visibility[1] (McGuire, 2016) from Fed transparency.  Mindful of their inability to provide significant visibility, the Fed has said that the unfolding of economic data (data-dependent) would guide Fed officials in determining the appropriate timing of policy normalization moves.  Now however, the Fed is indicating the very nature of the economic data gathered brings into question their ability to determine the correct policy response.      

Fed Chair Yellen appeared to make every effort possible in her June 6th speech ‘Current Conditions and the Outlook for the U.S. Economy’ delivered at The World Affairs Council of Philadelphia to convey a message of doubt.  She noted; ‘In particular, an important theme of my remarks today will be the inevitable uncertainty surrounding the outlook for the economy.’  Indeed, she offered just that.  Chair Yellen did describe current conditions, but she did so in relation to a discussion on uncertainty.  She used the term uncertain no less than 15 times in here remarks.   So conveyed was the notion that there can be no monetary policy guidance at this stage that it is surprising that financial markets did not react more violently.

It is widely understood that a good accounting for the effectiveness of Fed transparency is gauged by the amount of market volatility immediately following the post-FOMC meeting communication.  If the Fed is able to provide a good sense for the conduct of monetary policy and thus likely outcome of the FOMC deliberations, asset prices should be fairly adjusted to a post-meeting message.  It is argued such transparency leaves little room for asset price volatility thereafter.  Fed Chair Yellen made clear in her recent speech that even if there was a willingness to provide such guidance, it was simply beyond the capacity of the Fed to offer any direction in monetary policy prospects given current conditions.       

Because of the Feds difficulties parsing current economic conditions, it is realistic to expect some change in the dynamics between the meeting statement and market response from this and possibly future FOMC meeting deliberations.  Under circumstances less desperately described as Chair Yellen noted in her June 6th speech, market participants could be rather confident that post-meting volatility would be checked or tempered by the likeness of the statement message to the pre-meeting conditioning.  At the June meeting however, meeting participants (as well as economic agents at large) may have quite dissimilar views, sculpted in large part by more recent economic data which could prompt a message and policy direction quite alien from what the market has currently priced.  

In any event, it is quite conceivable that economic agents are prone to respond more aggressively to any post-meeting message than at any time in recent past.  Chair Yellen indicated the highly unpredictable unfolding of economic conditions with implications for similar uncertainty as regards monetary policy.  Under such circumstances, the reaction to post-FOMC meeting communication could be considerably more volatile than what has been the longer run norm. 

There are two primary reasons for a greater chance for market volatility following the FOMC meeting.  First and most obviously, the Fed may leave more unsettled the chance for a policy response in July.  Secondly, it may more largely distance itself from the prospects of a July rate response.  In the first instance, reduced visibility would lead to greater volatility.  More importantly perhaps, in the latter, the creditability of the Fed’s long held commitment to a gradual pace for monetary policy ‘normalization’ is threatened.  As such, the Fed has ample reason to indicate at a minimum that the July meeting is still ‘live’, if not a likelihood for a policy response.   

Had the initiation of ‘normalization’ been delayed, possibly from December to March, the notion of gradual might still apply.  However, should the Fed be required to postpone the next rate response beyond July, the very idea that policy normalization is progressing would be at stake.  Even as the Fed has made perfectly clear that data dependence is at the forefront of policy deliberations, gradualism supposes that the unfolding of that economic data will allow for policy movement.  Otherwise, it simply would not be fit for the Fed to qualify its course of action as gradual. 

It is the nature of that data unfolding which is expected to provide reason for a gradual pace for policy normalization.  Economic agents might rightly differ as to their understanding of the limits to the delay between policy moves which could still be considered as gradual.  However, if policy response is not seen in a timely enough manner to qualify largely as gradual, then it must be assumed that there is really no ‘path’ (gradual or otherwise) for policy rates and the Fed is operating in ad hoc fashion.

The implications for financial market stability are not small when considering operation under ‘gradual’ verses an ‘ad hoc’ frame of reference.  Gradual implies a policy path, which though not strongly defined allows some capacity for predictability.  This policy path aspect or implication of gradualism in terms of monetary policy application invites stability as it lends visibility through Fed transparency.  Monetary policy operated under an ad hoc framework simply cannot provide any such policy path framework and would therefore more generally lend itself to promoting rather than reducing volatility.    

Further, a gradual pace for monetary policy action implies some ability to model such a framework.  That is gradualism implies some regularity or degree of predictability which can be used in model building.  Whether that predictability is fitted into multi-variable econometric models or simply assimilated into the projections of average consumers, a change to a less predictable state can have dramatic repercussions.  They will likely reduce both the value of the output from econometric models and would of course reduce the willingness of consumers to spend and businesses to invest. 

Models built upon projections for monetary policy are often more robust when they are kept uncomplicated.  Right now, many models using policy projections presume a slightly less than gradual pace for policy firming.  This is evidenced in the pricing of interest rate derivatives (futures and options) that assume rate firming of less than 50 bps per year over the intermediate term of 1.5 years.  These models are stretched to their limit in their ability to provide meaningful output.  It is difficult for these models to recognize as a continuous policy regime, policy action that is separated by more than six months.  Using recognized economic projection techniques, there is little room beyond current conditions to provide meaningful model output from even less timely policy responses.  They simply become too distant from one another to be considered consistent with one policy regime and instead become ad hoc or distinct. 

While there has been more than a few who suggested the December rate hike would be the only such removal of accommodation (‘one and done’), the Fed has clearly not given up on the notion that further accommodation removal will be appropriate.  In order for financial conditions to remain calm following the June FOMC meeting statement, the Fed will need to give some assurances that the data has been sufficient to warrant strong consideration for July as a next-response meeting.  Otherwise, the notion of gradual policy unfolding is lost and Fed guidance, largely absent for nearly two years is completely missing.  Without stronger economic performance, a rudderless monetary policy might be too difficult a burden for economic agents to bear and a wide scale reduction in risk appetite could ensue. 



We are therefore very cautious on the approach of the June FOMC meeting and while we suspect the Fed will provide assurances that they are still operating similarly and that July is a ‘live’ meeting, unless they can make such an argument believable, a strong ‘risk-off’ preference could prevail. 


[1] [i][i] ‘Visibility’ (The ability to see or be seen; the quality or state of being known to the public) as regards monetary policy is very much different from ‘transparency’ (Transparent-able to be seen through; honest and open: not secretive) in that visibility is something that can be seen whereas transparency only speaks of the lens by which reality is viewed.  Think of a windshield as providing transparency for a driver.  A clean windshield allows the driver to see clearly the road ahead.  A muddied or rain splattered windshield would limit the transparency of the window regardless of the situation ahead.  Visibility is the extent the drivers view is unobstructed beyond the windshield.  If he is on a long, straight and open road, his visibility is high.  If he is on a crowded and highly curved mountainous road, his visibility is limited. 
The Fed can more easily keep the windshield clean (muddied) as it prefers in providing information (keeping information secret) to the public than it can produce ‘visibility’.  It offers visibility when it provides believable assurances as to when and how it will adjust its monetary policy.  Currently, the Fed does not have a level of confidence in economic and financial market projections to provide much visibility outside of indicating that it does not intend to end reinvestment of interest and principal for its securities holding until policy rate normalization is well underway. 

Can you imagine any ‘policy paths’ the Fed might create that would provide additional ‘visibility’ that either do not currently exist or have been overlooked as a source for increased financial market stability?  Did you realize that the reduction of latest purchase program in incremental format was an engineered ‘visibility’-add.  Intended or not, this addition of visibility provided greater understanding to policy intent which attracted higher levels of risk assumption than would have been the case in its absence.  Note that when then-Fed Chair Ben Bernanke had in mid-2013 discussed removing or reducing the purchase program without providing a ‘policy path’ for that outcome, the market responded violently to a loss of ‘visibility’ in the purchase program that existed.  It was not until the ‘policy path’ for purchase tapering was unveiled that economic agents again had a renewed sense of policy awareness.  This of course contributed to greater economic growth than available in its absence. 
                                                            

Wednesday, April 27, 2016

FOMC Report April 26-27, 2016; Financial Market Calm With Unimpressive Growth



Executive Summary:  No reason to expect policy change at the April FOMC meeting.  Shifts in assessment of recent economic growth and global financial stability and will offer insight into how the Fed currently sees itself proceeding in June.  In order to bolster a case for a June policy move, the Committee may reinsert its balance of risk statement indicating a ‘nearly balanced’ appraisal.  Otherwise, even a possible descent by Kansas City Fed President George will not surprise Fed watchers.

Overview:          

Global financial and economic conditions were overriding sources for concern when the FOMC in March decided to delay subsequent monetary policy normalization initiative.  Having first raised policy rates in December without much time having elapsed the August market turmoil, few expected the Fed to adjust policy rates again following a repeat of market disquiet earlier this year.  While calmer financial markets welcome the April FOMC meeting, economic performance does not itself provide ample justification for hurried Fed response. 

Economic reports indicate a good likelihood that economic growth since the start of the year has been less than 1 percent.  If Fed officials hope to move forward even with the dramatically curtailed normalization plans of 2016, they still need more than reduced financial market volatility as a basis for proceeding.  Slowly evolving inflationary conditions moving the benchmark nearer to the two percent target within the medium term would provide some support for keeping a rate hike in the not so distant future on the table.  However, without stronger real economic growth, the likelihood for higher inflation moving forward is diminished and a return of financial market strain would be of greater concern.   
 
For the Fed to return to any recognizable ‘path’ for policy rates, acceptable levels of financial market stability must remain and economic performance must return at least nearer to its modest two percent projected potential.  It would be difficult otherwise to expect economic agents to envision any additional policy normalization in the near term, let alone a succession of policy responses that might be viewed as a ‘policy path’. 

Without greater predictability of intermediate term monetary policy directive, economic agents will require longer periods of sustained economic growth and more lasting financial market stability before accepting greater levels of risk in the implementation of their business plans.  The Fed has repeatedly advised that it is on a gradual pace for normalization and that it will be ‘data dependent’ in its application therein.  Even though it has promised otherwise, at this stage the Fed would delight if their primary problem was an economy that was growing at such a steady pace and inflation was so solidly rising toward its objective that a series of successive or skip-meeting successive policy moves might be necessary to prevent an overheated economic condition. 

Such a scenario may have been envisioned as a policy problem late last year when at the December FOMC meeting, the median forecast was for four policy responses (100 basis points) of accommodation removal within this year.  Unfortunately, concerns for how the Fed might orchestrate four rate hikes this year without appearing to have entered a too predictable policy path has for now passed.    

Weaker growth in China has been a source of stress on financial markets over the last months, contributing to the weakness in commodity prices.  Oil is one such commodity that was impacted by China weakness.  Oil prices (WTI), having already fallen from above $100 in mid-2014 to nearly $40 by August of last year, experienced another sharp decline into mid-January as weaker China and European growth seemed to threaten prospects for global growth more fully.

There had been growing concern that lower oil prices might trigger additional financial market strain through the failure of leveraged borrowers in oil production, especially newer forms of fracking which had attracted aggressive financing techniques.  Unmet financial obligations due to weaker oil prices it was expected might impact credit conditions more broadly, having adverse effects on lending activity more generally and further hampering already modest economic growth prospects. 

Monetary Policy Theory

One of the lesser understood monetary policy theories might be that the application of monetary policy when overwhelmingly understood or predictable, is apt to provide an inducement for economic agents to take on greater levels of risk, all else equal, than would have been assumed without that confidence in understanding the path for monetary policy.  This is an easy enough notion to digest when discussion revolves around easy monetary policy regimes where the support from Fed transparency is more universally appreciated. 

However, just as greater monetary policy ‘visibility’ [i] lends itself to greater levels of risk assumption during weaker economic times and the absence of animal spirits; the same forces are at play when the Fed provides predictable policy roadmaps during the removal of policy accommodation.  As it is, present conditions beg for this dynamic to be better understood.  Currently economic conditions appear somewhat fragile and policy rates are so close to the zero bound they prompt policymakers to take excessive caution in firming policy conditions because of concerns for having little room to reverse course without running over the zero bound. 

This is why financial stability is so very important at this stage.  It gives the Fed some level of confidence that they might provide economic agents some policy path for the return to more normal policy rates.  Economic agents too are more inclined to regard successive policy rate hikes as appropriate policy, should financial stability prove longer lasting here.  Instead, there remains a strong difference between what the Fed has indicated they plan and what the market has priced in rate hike expectations.

Greater financial market stability at this stage could shape economic agent expectations closer toward harmony with the Fed’s interest in raising the policy rate, thus creating an environment for self-sustaining growth through the add-on benefit of policy path visibility.  Fed officials should expect that even though policy rates would be moving higher, economic agents responding to a greater surety for a ‘policy path’ would increase their level of risk taking in accordance with still modest policy rates, though greater visibility in the policy path.

It is therefore more important at this stage for financial market stability than it is for stronger economic performance because the former begets the latter, while the latter may come and go without the former.  In the present context for the April FOMC statement therefore, the Fed will likely want to emphasize strengthened financial market conditions since the last meeting and downplay the implications of a repeat in the annual underperformance in Q1 growth (a near-annual event since 2010). 

Those who would doubt the likelihood for a positive response, in terms of higher levels of risk assumption as result of the introduction of a ‘policy path’ transparency during a restrictive policy initiative, need only review the conditions and outcome of mid-2004 to mid-2006. [ii]  

Current Monetary Policy:

Financial stability has improved over the last two months, not in small part due to the rebound in oil prices.  Additional financial market stability or at least longer lasting stability is needed before the Fed again is likely to adjust higher its policy rate.  This is largely why the Fed will not move the fed funds policy rate higher at the April meeting.  The Fed could however help ready economic agents for a policy response at the June meeting. 

Although the Fed has repeatedly indicated that ‘every meeting is live’, as in they could adjust rates at any meeting, most believe that a policy move is better suited to the quarterly meeting were Chair Yellen is afforded a scheduled press conference and the Committee publishes its Summary of Economic Projections (SEP).  All else equal, and with an interest in promoting visibility and financial market stability, we should expect the Fed to prefer to make its next policy move on a scheduled quarterly meeting.  

Two variables that likely prevent the Fed from hiking rates at the April meeting is the absence of lasting financial market stability and recently weaker economic growth.  We should look with particular interest on how the Fed emphasizes these variables in its post meeting statement as it will give insight as to how prepared they are currently to move forward with a rate response in June.  If the Fed acknowledges financial market stability while downplaying Q1 slower growth levels, then we should expect the Committee is leaning toward a June policy response.  Otherwise, a show of strong disappointment in recent growth and only a modest acknowledgement to improved financial conditions would suggest the Committee is less likely to act in June.

Because additional information both in the form of strengthened economic performance and more lasting financial stability will likely be necessary if the Fed is to raise policy rates in June, it is almost a certainty that there are no assurances given in the April FOMC Statement for a policy response in June.  All else equal, the Fed would rather make the next move in June rather than in July so they are very likely to leave the door on a move wide open.  It may be enough to upgrade financial market stability and indicate global (rather than domestic) economic growth has improved to indicate an interest in raising rates in June.

Because a majority of economic agents believe he Fed more likely to adjust policy rates at quarterly meetings (March, June, September and December), it makes sense that either the Fed condition economic agents otherwise or take advantage of current perceptions and foster financial stability by delivering that which is expected.  This suggests there is a stronger chance for the Fed to move in June rather than July.  What the Fed gains by waiting till July for additional information, it gives up in stability benefit from moving on a quarterly meeting.
 
All else equal, the market is not currently priced for as great a chance for a June policy rate hike as we believe the Fed is likely to present.  Clearly there will need to be additional financial market stability and a return to decent domestic economic growth for a June rate hike to become a reality.  However, in the short term following the FOMC statement, markets appear more likely to price greater rather than lesser chances for a June rate hike. 


[i] ‘Visibility’ (The ability to see or be seen; the quality or state of being known to the public) as regards monetary policy is very much different from ‘transparency’ (Transparent-able to be seen through; honest and open: not secretive) in that visibility is something that can be seen whereas transparency only speaks of the lens by which reality is viewed.  Think of a windshield as providing transparency for a driver.  A clean windshield allows the driver to see clearly the road ahead.  A muddied or rain splattered windshield would limit the transparency of the window regardless of the situation ahead.  Visibility is the extent the drivers view is unobstructed beyond the windshield.  If he is on a long, straight and open road, his visibility is high.  If he is on a crowded and highly curved mountainous road, his visibility is limited. 

The Fed can more easily keep the windshield clean (muddied) as it prefers in providing information (keeping information secret) to the public than it can produce ‘visibility’.  It offers visibility when it provides believable assurances as to when and how it will adjust its monetary policy.  Currently, the Fed does not have a level of confidence in economic and financial market projections to provide much visibility outside of indicating that it does not intend to end reinvestment of interest and principal for its securities holding until policy rate normalization is well underway. 

Can you imagine any ‘policy paths’ the Fed might create that would provide additional ‘visibility’ that either do not currently exist or have been overlooked as a source for increased financial market stability?  Did you realize that the reduction of latest purchase program in incremental format was an engineered ‘visibility’-add.  Intended or not, this addition of visibility provided greater understanding to policy intent which attracted higher levels of risk assumption than would have been the case in its absence.  Note that when then-Fed Chair Ben Bernanke had in mid-2013 discussed removing or reducing the purchase program without providing a ‘policy path’ for that outcome, the market responded violently to a loss of ‘visibility’ in the purchase program that existed.  It was not until the ‘policy path’ for purchase tapering was unveiled that economic agents again had a renewed sense of policy awareness.  This of course contributed to greater economic growth than available in its absence. 

[ii] The ‘measured pace’ restrictive policy initiative was an example of how strong an influence policy ‘visibility’ can be in encouraging economic agents to take on greater levels of risk.  It was the strong sense of certainty economic agents held for their understanding of a large piece of the Fed’s policy timeline that encouraged them to take on as much risk as they did.  Without assurances that the Fed would only remove accommodation at a modest measured pace of 25 basis point increase every 6 weeks, economic agents were far less likely to accept the level of risk they assumed which drove out economically viable investment, leaving only malinvestement in its place.   

Tuesday, March 15, 2016

FOMC Report March 15-16, 2016; Enough Growth, But Too Much Volatility



The Fed’s major interest at this point is in achieving financial market stability. Economic agents seem to be more concerned than Fed officials about that prospect. If the Fed can find financial market stability in the short run, it will be more confident in achieving its dual mandates in the longer run.

If stability is lost, so are its longer term goals. After nearly seven years of repair, stability rather than excess is the bigger issue. There have been modest signs of excess in areas like sub-prime auto loans, tighter credit spreads in general and a strong appetite for leveraged loans.  However, the greater disruptive force limiting both economic potential and frustrating the Fed in its desire to ‘normalize’ policy has been the rolling nature of economic performance. 

Market dislocation, having lasted beyond the December FOMC decision to initiate a rise in policy rates, will keep the Fed from raising rates at the March FOMC meeting.  The statement following the meeting along with the message from Chair Yellen in post meeting press conference will indicate a greater confidence in current prospects with recognition of ‘nearly balanced’ conditions.  The Summary of Economic Projections (SEP) will likely indicate an expectation for one less 25 basis point policy rate rise this year in deference to the lengthened financial market volatility earlier this year.  This change will similarly affect later period end points.  However, the longer term equilibrium fed funds target is not expected to fall.    

A cyclical tendency toward economic growth has evolved since 2010 that has allowed expectations for above trend growth seen regularly toward mid-year to be mistakenly extrapolated into forward quarters. As such, while annualized growth exceeds the Fed’s current longer range growth expectations, the volatility in economic growth associated with achieving that outcome creates uncertainty. An uncertainty the Fed does not care for or care to add to.

With annual economic growth at its current pace, but absent the extensive quarterly variance, economic agents would likely be more comfortable with the Fed’s continued movement toward monetary policy normalization, even in the face of divergent other Central Bank activities.

Repeatedly over the last five years, periods of heightened expectations for growth give way to more disparate views of prospects and additional cautious applications of spending and investing.  It is the variability of growth rather than the longer term outcome that distracts and heightens concern which derails both the Fed from normalizing policy and detracts consumers and businesses from spending and investment plans.  Even if growth was marginally slower, but less volatile than seen over the last two years, it is likely economic agents and the Fed itself would be quite comfortable if prevailing policy rates were nearer to 1% at this juncture.

The current backdrop is in line with domestic growth achieving an intermediate-term pace equivalent to or marginally above the Fed’s projected longer run potential while inflation is likely to move at a slightly quicker pace toward its 2% target.  Real GDP (chained ‘09) has grown at a 2.4% YOY pace over the last four quarters and at the same pace over the last two years. Further, the average YOY real GDP growth seen over the last four years is 2.1%. Comparing recent annualized as well as more protracted real growth levels to the current SEP longer run projected 2% potential provides support for a policy rate that is higher than 0.25-0.5% in the absence of vacillating performance.

The degree to which economic agents have been affected by the unsteady nature of economic progress is demonstrated in the enclosed chart of the Citibank Economic Surprise Index – United States (Source: Bloomberg LP). Here a cyclical tendency in the flow of economic data is quite evident. It is apparent that stronger economic growth in mid-year is extrapolated, but not achieved. Softer late-year growth too is over-emphasized and the data series once again outperforms expectations, setting up an annual recurrence. We appear to again be at the point where weak late-year growth is found not to have been as lasting as earlier feared.

Note also the rather modest swing in the Economic Surprise Index since early 2015 relative to that seen in prior years.  It could be that economic agents are simply becoming less surprised in the cyclical nature of economic data.  In any case, a reduction in over-reaction could help to bring in line the data itself on a path more conducive to the Fed ‘normalizing’ policy rates.  

 

 


Fed does not want to add to either economic variability or the overshoot or undershoot of expectations, but rather would be quite content with growth that is steadier toward 2% (or greater) on a quarter by quarter basis.  Mainly because of the current rate structure, Fed officials have to walk a fine line in order to ‘normalize’ policy rates given the concern for adverse response in attending those interests.  Market expectations are for the Fed to refrain from adjusting policy rates at this meeting.  A decision to raise policy rates now even if economic data can be used to justify, would add a measure of financial market volatility and distress that cannot be reckoned with a goal of achieving steady growth.