Monday, March 13, 2017

FOMC Report March 14-15, 2017; Quarterly and Orderly

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.   

Cautionary Note

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.   

Monday, January 30, 2017

FOMC Report Jan 31/Feb 1, 2017; A Veiled March Door Open?

Executive Summary: 

The FOMC statement is expected to read modestly upbeat with regard to economic prospects without offering any great assurance that a policy move should be expected as soon as the March 2017 FOMC meeting .  Still, we view the risk for language adjustment in the FOMC statement as leaning toward a stronger or more hawkish message than is widely expected.  While the impact of changed US Executive Branch policies remains uncertain, prevailing trends over the last months may be sufficiently positive in their own right to warrant modestly accelerated accommodation removal.  Finally, should the Committee wish to open the door to a March policy response, it is more likely to provide that clue in its discussion on inflation rather than growth or reduced global concerns. 
Current Conditions

Recently released Q4 GDP data showed less robust than expected at 1.9%, given a meaningful subtraction from net exports (-1.7% ) – the greatest shortfall since 2010.  This still leaves H2 2016 GDP at greater than 2.7% and robust in comparison to that seen over the last years. 

Year over year Core PCE, the fed’s favored inflation gauge, increased at 1.7% in the latest December reference.  This latest read is above the November and 12 month moving average and not terribly far from a dual mandate goal of 2%.  

Recent gains in equities along with modest recovery in Treasury Securities prices since mid-December have benefited financial conditions and have given support to increased economic activity.  Measures of market implied volatility have been low, indicating some level of confidence.  The VIX Index recently traded to its lowest reading since mid-2014.  The Merrill Lynch Move Index, a measure of Treasury security implied volatility is below the 50 day moving average and nearer to the low seen since early November.           

Some Sense of Urgency       

Economists are abuzz discussing and interpreting the implications for an earlier introduction of the normalization of the Feds balance sheet.  The FOMC statement due Wednesday afternoon is not expected to offer any additional evidence that the Committee is strongly considering moving forward its intended implementation timing for stopping or curtailing regular reinvestment. 

A majority of FOMC Committee members are expected to favor additional normalization of the fed funds policy rate before any movement toward balance sheet adjustments are made.  Currently the Feds stance is that balance sheet adjustments would not commence until policy rate normalization was well underway, believed by many to imply a fed funds level somewhere toward 1.5%.  The best argument we have heard for a substitution of balance sheet adjustment for policy rate hikes in efforts to remove monetary policy accommodation is the expected benefit to capital investment (over consumer spending) in part resulting from a weaker dollar.

Using Inflation Language to Tweak Expectations

While it is not our base case to expect that the Fed will use the upcoming FOMC statement to signal strong desires to remove accommodation in the immediate futures (March), we are impressed enough with the elevated discussion of balance sheet reinvestment elimination and somewhat more constructive progress in both economic growth and inflation to make ourselves attuned to avenues which the Fed may use in offering meaningful policy hints. 

If the Fed were to make too strong a message of appreciation for economic prospects, a walk-back from that sentiment may cause too much confusion and cause more extensive volatility than the Fed would want.  Further, any stronger signal sent that world geopolitical conditions have brightened would appear more hopeful than instructive.  Finally, the Fed could make more pointed notice to stronger employment gains, the housing sector or capital investment than had been anticipated.  We see any more than a modest improvement in assessment of any of these areas as unlikely. 

If the Fed wishes to send a veiled message of interest in adjusting the policy rate as soon as March, it will more likely make comments about inflation as nearing its targeted level to open that door.  Focus on inflation, a relatively slow moving target, will allow Fed officials plenty of opportunity to later indicate that progress toward the inflation target has not been as steady or secure as earlier hoped for.  At the same time, if economic growth alone was to accelerate in a meaningful way, its implication for inflationary prospects will not be difficult to communicate. 


This FOMC meeting and statement are not expected to provide much excitement.  However, there is more than a minute risk that the Fed will want to push open the door for a March policy rate response.  If it is to do so, we believe the Fed will make that signal through its assessment of inflation conditions.  Otherwise, heightened interest in changes to the Feds balance sheet through reinvestment or sales of securities at a time sooner than earlier stated Fed intention is worthy of additional review.  For now, we simply imagine these discussions, especially when sponsored by Fed officials, will tend to support lower levels of implied policy rates over the coming year(s) and a steeper Treasury yield curve. 

Monday, December 12, 2016

FOMC Report December 13-14, 2016; New Fed Regime Party - 2nd Annual Policy Rate Normalization

The Federal Reserve is expected to raise its fed funds policy rate by 25 basis points at the upcoming December FOMC meeting.  To do otherwise at this point would cause confusion and reduce the near term prospects for growth.  Solid employment growth and more recent modest improvement in inflation conditions allow the Fed to move policy rates in accordance with its dual mandate objectives.  Still, the Fed is likely to be overly cautious in providing a message that the policy rate hike at this meeting is not expected to be followed by a series of such moves anytime soon. 

The last time the Fed raised its policy rate was a year ago and it has been since late 2007 that the Fed has made similar sized consecutive policy rate adjustments at regularly scheduled meetings.  Before last year, the last time the Fed raised policy rates was in June of 2006 and that too was 25 basis points.  June 2006 concluded 17 successive 25 basis point policy rate advances at consecutive meetings.  Following that scale of adjustments at the current annual pace would put fed funds at 4.5% in 2032.  Laughable maybe, but the message in the December FOMC meeting statement and that of Chair Yellen in post-meeting press conference will offer guidance closer to the latter pace of policy adjustment than the former.   

This slow move toward ‘normalizing’ policy is in line with the Fed’s determination to respond to the flow of economic data, which to date has prevented a more accelerated pace of that normalization.  The nature of recent domestic political change further allows the Fed to offer watchfulness as their immediate overriding interest rather than a concentration on the timing of additional policy application.    

Potentially A Long Awaited Growth Surprise
It has been pointed out many times over the last years that household balance sheets have repaired since the financial crisis and that these repairs were reason to expect a renewal of consumer spending, fulfilling a long-suppressed and pent-up demand.  Commercial interests too, with long-friendly financial conditions though absent consumer spending, were seen as at the cusp of greater capital investment once consumers opened their purses.

Instead, consumers, business leaders and therefore the Fed have been given successive, though sporadic reasons to delay any appreciable movement toward ‘normal’ or standard operating procedures.  Yet today, following a largely surprising political development, a shift in asset prices, which can only be read as movement toward pricing greater prospects for economic growth and possibly inflation pressure is under way.  Clearly there are those who would surmise the policies directed from a Trump White House and enacted in a Republican controlled Congress can boost economic growth in the near term.
On the back of recent political developments a modest minority have already engaged themselves in more elevated risk profile.   There is a much greater majority that is expected to become thus involved should a collection of data points over the coming months prove convincing that a stronger risk appetite is paying handsome dividends.  There will be a not so insignificant minority, who for absolute distaste in recent political developments alone, will refrain from actively engaging any bullish projections until a much later date.  It is the make-up of this dynamic rather than by virtue of particular political figures or their mandates which are expected to give any renewed growth prospects significant potential and help to create the very growth that has been absent these last years.   

Well before recent political developments, economic agents had priced greater than even odds for a rate hike before year end.  Expectations for that same small adjustment have become nearly unanimous as the market has reacted to events by adjusting Treasury yields higher in November by more than it has in any one month since 2009.  Higher long term Treasury rates have generally been interpreted as indicating expectations for stronger growth and greater inflation. 

Lately, Fed officials have more generally looked with favor on higher longer term Treasury yields and a steeper yield curve to the extent these point toward improved economic prospects, while benefiting the profitability of the banking system and therefore possibly its stability.  However, rates have risen sharply enough over the last month that the FOMC post-meeting statement is not expected to encourage any further steepening of the yield curve or substantial rise in US Treasury long rates.  Instead, the Fed will likely indicate that policy remains somewhat accommodative and that the prospect for growth and inflation, though uncertain, are roughly balanced. 

Finally, the Summary of Economic Projections (SEP) is expected to remain relatively unchanged with modest upward adjustment to employment, inflation and economic growth prospects in this and the next two years.  Real GDP projection expected higher by 0.2% to 2.2% for 2017 and 2018.  A lower projected unemployment rate (from 4.8% year end in September to 4.6-4.7%) is expected given the recent drop in November to 4.6%.  Otherwise, a modest 0.1% increase in expected Core PCE inflation is a possibility for this year and next (to 1.8 and 1.9% respectively).  The Fed policy path projection is not expected to change at this meeting.           

Monday, October 31, 2016

FOMC Report November 1-2, 2016; "Alright, OK, Make a Path"

Executive Summary: 

The Fed is again not expected to raise policy rates at this FOMC meeting.  We place the odds of a rate hike at 7% and the hike probability is this high largely because there were 3 dissenters at the September meeting (Esther George, Loretta Mester, and Eric Rosengren), otherwise the odds assumed would be even lower.  A stronger case for a November FOMC rate hike could have once been made if housing and production data had been stronger.  Even under such conditions however, there would still have been concern about the implications of a policy move immediately in front of a Presidential election.  Unless economic data had been overwhelmingly strong, economic agents would have found it difficult to price a policy move.  Assuming Fed officials had such a desire to ready market participants for a November rate hike, they would have needed a lot more ammunition than was made available in the economic and financial data since the last meeting.  We might again expect the statement to show a stronger collective interest in moving forward with a rate response at an upcoming meeting.  In this, economic agents will read upcoming as meaning the December meeting.  With the market already pricing greater than a 70% chance for a December hike, the post-Meeting FOMC statement need not be any more specific about their intent.  

“Alright, OK, Make a Path”

Never before has such an overwhelming amount of data or such extraordinary analytic capacities been available to those who study the economy, financial markets and monetary policy.  To this end, a growing majority has come to expect the Federal Reserve will provide a pace of accommodation removal that in golf parlance might be described as a ‘worm-burner’ (a shot which barely rises above ground level).  Those with great recall capacities will remember that the Fed did indeed remove a modicum of accommodation at its last yearend meeting.  If the Fed carries forward with policy prescription widely expected, then a second consecutive yearend modest removal of accommodation is forthcoming. 

Long a fan of policy paths, or more exactly, extremely fond of coming to terms with path implications prior to their being accepted as paths by a strong minority1, we cannot help but expect that the outcome from the December 2016 FOMC meeting shall prompt many to drawn a line from December 2015 and through 2016 December.  This line, with modest beginnings at 12.5 basis points finds reference marks at both 37.5 basis points (mid-point of current policy target range) and if a large majority view is correct in anticipating a Fed policy response at the December FOMC meeting, then an intersection again at 62.5 basis points is expected.  A cleaner line cannot be drawn.  There is no curvature offered and it shall be expected to strike both 2017 December and the year following December at 87.5 bps and 112.5 bps respectively. 

Old dogs and young pups search again a spot where success was found in the past.  Apart from their studies, the financial market equivalents of young pups have experience concentrated in policy rate data points hovering at or about the zero bound.  Old dogs, having long ago found meat at higher policy rate grounds have struggled to pick up the scent at these lower policy rate grounds.  Old and young and all breeds irrespective will be drawn toward the policy path described by 25 basis points at each December FOMC meeting.  Whether conscious or otherwise, decisions will be swayed by this simple policy path projection. 

There shall be such a force directing expectations for a third and fourth point falling on the policy path line that evidence arguing against will need to be overwhelming before it will sway a majority of economic agents.  As such, advanced knowledge or understanding that data is or will continue to argue for a stronger (or easier) policy response will not at first be an advantage if one acts in accordance too early.  Instead, expecting strong resistance against pricing a steeper (or less steep) policy trajectory will benefit the patient position taker. 

It is probably worth remembering a bit of recent history surrounding yearend December FOMC meetings.  At the December 2013 FOMC meeting, the Fed answered the question that was of concern since mid-year.  The trial balloon that Fed Chairman Ben Bernanke tried to float concerning the lasting nature of the securities purchase program blew up in his face because he failed to attach to that inevitability a policy path.  That trial balloon resulted in what became referred to as the ‘taper tantrum’ and it would not have happened had the Fed done in mid-2013 what it eventually got around to doing at the yearend December 2013 FOMC meeting, providing a policy path for tapering securities purchases.       

It was not the proposed reduction of securities purchases that spooked the market.  Rather, it was the not knowing any particulars of such a reduction that economic agents found mortifying.  Frankly, they hung to assurances offered in the modest amount of transparency provided by policy path described by the purchase program regularity, like the drowning to a flotation device.  When Bernanke took those assurances (the policy path of securities purchases) away, the market reaction was similar to that of someone drowning.  

Had Bernanke in mid-2013 simply substituted the policy path of the purchase program with a policy path for tapering the purchase program, as was eventually done, but little expected at the December 2013 FOMC meeting, there would likely never have been the famous ‘taper tantrum. 

Another standout December policy action took place at the December 2008 FOMC meeting where the policy rate was reduced by 75 basis points and where a target range (0-25 basis points) was first introduced.  That policy rate of course held until last December 2015 when the target range was increased by 25 basis points to 25-50. 

The Fed has an opportunity to add the market calming effect of policy path if it raises policy rates at the December meeting.  By doing so, the already low market implied volatility should be expected to stay well offered for some time until a strong challenge can be made against the status quo of annual minuscule policy rate adjustments. 

1)    The Fed and Interest Rates: ‘A Pause in August means a Pause in September’ FOMC Report - August 8, 2006

For quite some time my basis for Fed projections has been that the visibility provided by the Feds transparency in the prior period of ‘path-dependent’ policy directive was sufficient to prompt higher levels of risk assumption than would normally have been the case in a less predictable, restrictive policy directive. The removal of visibility resulting from the recent change to a ‘data-dependent’ policy directive (irrespective of any level of transparency) should prompt some unwind of excessive risk exposure that was enjoyed during the period of greater visibility.

Tuesday, September 20, 2016

FOMC Report September 20-21, 2016; Monetary Policy in the Awkward Middle

Executive Summary: 

The Fed is not expected to raise policy rates at this FOMC meeting.  The odds of such a rate hike are at 10% by my estimate and remain this high because of the particularly disjointed message received from Fed officials since their meeting in July.  A stronger case could be made for a policy response at this meeting, but such a unified message was not articulated by Fed officials.   Economic prospects rather than overwhelming evidence from current conditions are not believed sufficient to carry a decision to raise policy rates at this meeting.  Instead, a stronger message in the statement and post meeting press conference will be the concession to the more hawkish Fed contingent.       


Monetary Policy in the Awkward Middle

Federal Reserve monetary policy has returned to the ‘no man’s land’ between easier and firmer monetary policy regimes.  Despite ever increased central bank communications and continued efforts in increasing transparency, the Fed appears increasingly less able to impose an imprint even on policy actions, much less economic activity.  Fed talk of firmer policy initiatives down the road gets pushed to the shoulder as each initiating point comes more clearly into view. 

At this stage, the initial December 2015 rate hike is so far in the rearview mirror that to suggest that a next rate response is connected would be a stretch.  The notion of ‘gradually’ returning to a more normal policy stance while being governed by a ‘data dependent’ yardstick has offered communication challenges from the start.  While the former implies some regularity, the latter is both suggestive of a rule-based approach and at the same time left to interpretive influences.  The Fed has tried to straddle the line between providing guidance and allowing expectations for their policy initiative to be interpreted by reading into the flow of economic and financial data.  This would of course be made easier if everyone was in agreement as to what the Fed’s reaction function is or should be.   Interpreting monetary policy from economic and financial market data is made all the more difficult because is no universally recognized Fed reaction function.

For now it is important to recognize that policy mistakes made in the middle ground between an easy and a restrictive policy regime carry greater weight.  While both sides of the policy regime coin offer the market stabilizing influence from a known, implied, envisioned or imagined ‘policy path’, that stability of policy path is absent as the coin stands on its side between heads and tails (accommodative and restrictive). 

When the Fed is widely understood to be carrying out a restrictive monetary policy initiative, some adjustment should be expected as data comes to light that does not jibe with market expectations for already priced pace for the removal of accommodation.  Similar conditions exist for easier monetary policy regimes.  However, market adjustments made when neither policy regime is in place tend to be of greater magnitude because economic agents have less confidence in their ability to interpret the monetary policy response to changes in current conditions.  The lack of a monetary ‘policy path’ leaves absent the potential for modest scaling to or from those prior expectations.  Instead, in the monetary policy middle ground, each modest outlier from expected data requires a reformulation of policy expectations and thus greater market volatility.     

As such, when the Fed finds itself between policy regimes and without a more firmly recognized policy path, it is all the more likely to delay a policy response that is not more widely expected by economic agents.  This is true at an extreme where policy rates had earlier been driven higher and have peeked before coming lower, but is even more important to understand this when policy rates rest nearer to the zero bound. 

We should therefore not expect the Fed to firm policy rates at this September FOMC meeting.  The risk for surprising economic agents does not appear likely to be offset by any sizeable benefit from raising rates.  Therefore, it is more likely that more hawkish Fed officials will position for is a stronger statement and more upbeat assessment in the post meeting press conference.


Summary of Economic Projections

The Summary of Economic Projections (SEP), is expected to show a majority of Fed officials are looking for one ‘additional’ rate hike this year.  Even though there has been a strong voice within for the Fed to firm policy rates, the continued discussion of low and falling equilibrium level of interest rates (r*) suggests that the path for policy rates implied by the ‘dot plot’ will be reduced through 2017-2018.  In line with gradual reductions in forward expectations in the past, it is likely that the median estimates for 2017-2018 and even longer run will be reduced by roughly 25 bps.  It is not as clear that the longer run fed funds rate will be lowered at this meeting.  This may be a concession that the Fed doves can give in order to placate the officials with more hawkish desires.  GDP growth for 2016 will likely be scaled back further (1.7-1.8% from 2% June) because of a slower than expected Q3.  The balance of the SEP is not expected to see great change.