Wednesday, January 27, 2016

FOMC Report January 26-27; Leaving Door Open to March Hike

Executive Summary:
There is little reason to expect policy rate action at this meeting.  Though financial conditions have been volatile and economic data has been somewhat softer, job gains continue to surprise on the upside.  Inflation expectations have improved slightly while market based indicators slipped from already low levels. 

The post-meeting statement is likely to refer to economic growth as moderate, but could note slowing in consumer spending and manufacturing.  Dollar strength, foreign economic weakness (China) and global equity market volatility may be noted as areas that deserve continued monitoring. 

Otherwise, the door to a March policy rate move will be left open with risks seen as ‘nearly balanced’, from ‘balanced’ as characterized when the FOMC met in December to first raise rates.  Unity of purpose may limit the possibility for dissent from more hawkish Fed Bank Presidents who might have instead argued for consecutive meeting policy rate moves in the absence of recent market disquiet. 

Going Forward:
There is no reason to pretend no danger exists from recent market volatility and many economists have rightly marked down marginally, current growth prospects for reasons of increased financial stress.  However, we are not inclined to make more of recent dislocation than is prudent.  There are those who argue that the Fed should have anticipated the negative reaction from raising policy rates and that the mistake was obvious given slow global growth and the absence of verified increasing inflation at home. 

If financial markets continue to show signs of stress to the extent that real growth is significantly impacted, the Fed should longer postpone further removal of accommodation.  Otherwise, current monetary policy conditions are still extraordinarily supportive, to the point of providing incentive for malinvestment.   The Fed wants to remove that incentive.  While it is difficult in the midst of financial market turmoil to recognize any benefit therein, to the extent the December policy rate adjustment has prompted economic agents to more thoroughly examine risk tolerance and exposure, it is in the Fed’s interest in helping to provide for sustainable growth. 

Mechanized v. Gradual
As difficult as may be given current attention to disquieted markets, we shall endeavor to put forth a base case for the Fed in the early going of policy normalization as regards the policy rate.  If as suggested above the Fed does not want to continue a policy stance that encourages malinvestment, they will want to move forward with additional policy rate firming while at the same time refraining from making policy moves so predictable that they are emptied of influence. 

The Fed’s challenge, if markets quiet from recent disruptions is to carry forward in removing accommodation guided by longer run equilibrium levels, while giving voice to the value of slowly evolving and over the short run, volatile economic data.  To move policy rates consistently at quarterly FOMC meetings will prove as ineffective as was the efforts in ’04-’06.  Instead, the Fed has to occasionally mix up the pace, if not the level of accommodation removal.  The latter is too harsh a prospect in the early going especially given financial market volatility, so the Fed will be required to provide some variability in the pace of accommodation take up. 

My base case remains for a second quarterly firming in March followed by a pause in that pace by not hiking in June, but following instead with a July meeting move.  By moving in such a fashion, the Fed will have indicated a commitment toward its plans of removing accommodation while it avoids being unnecessarily predictable. 

Leaving the door open to a March policy rate change in communication following the January FOMC meeting, will provide support to financial markets.  It is not the Fed hike in December that has disrupted markets and a Fed overreaction to recent disquiet would only promote additional upset conditions.  It costs nothing to leave that door open and it would cause more problems to have to break that door down if labor markets continue to improve and inflation moves higher in quieting financial markets.  A steady hand is called for by the Fed and they have given such indications over the last weeks.  We should expect they conclude their confab with appropriate concern and the foresight to continue forward with earlier stated intentions to remove accommodation in a gradual and data dependent fashion.    

To stop at one hike upon leaving the zero bound, is to call it a mistake.  To recognize policy action within 6 weeks as being a mistake may be without president.  Instead, even if there is heightened concern as relates to the weakness in China’s economy, the global equity market and energy and commodity prices following the December rate hike, the Fed need not credit those developments to a policy mistake. 

Economic growth still exceeds its assumed longer run potential and employment growth continues to reduce an already diminished human resource slack. 

A pause from additional accommodation removal in March, now largely anticipated and priced, would be a mistake as it would give rise to heightened concern.  Instead, a steady commitment to adjusting the policy rate higher will be seen by economic agents as a welcome constant and consistent with a confidence in the lasting nature of domestic growth. 

Recent equity market weakness and likely some of the reason for lower oil and other commodity prices is the increased acceptance that China is experiencing some difficulty in adjusting their economy from a ‘producer for the world’ status to self-generated or domestically induced internal growth.  Unfortunately there is no cookie cutter guide to redirecting the second largest economy in the world.  Those who would argue that recent developments in China give rise to current financial market disquiet are mistaken.  Instead, it is the awakening of the masses today to conditions that have been developing for years that is driving current risk-off decisions.  Instead of getting worse, China is further along in the bumpy road toward internally generated growth.  The pains of that transition are today as acute for the global economy as they ever will be.           

Finally, we should expect the Fed to remain judiciously aware of recent market disquiet without improperly connecting that activity to their December FOMC meeting decision.  Going forward it is more likely that financial markets quiet and it will be some relief that the Fed had not overreacted.  

Tuesday, December 15, 2015

FOMC Report December 15-16, 2015; Onward Toward ...ahem, 'Normalization'

 Onward Toward ...ahem, 'Normalization'

Executive Summary: 

Expect the Fed to raise policy rates by 25 bps, where the fed funds are likely to continue to trade between the corridor of interest paid on excess reserves (IOER) on the upside (50 bps) and the overnight reverse repurchase rate (RRP) below (25 bps).  We should expect no effort spared in conveying the message that future policy initiatives will be directed by incoming data.  At the same time, it will also be stressed that only a modest and gradual policy response will likely be required in the face of continued attainment of dual mandate goals projected.  Transparency continues to play a role in policy communication and I was surprised by the comment made by Chair Yellen at her December 2 outing concerning the importance of the ‘dot plot’.  We should probably expect that the longer run equilibrium rate will be reduced and highlighting that likely change will somewhat direct attention away from the fact that policy rates have been risen for the first time in a decade. 

Guidance During Normalization:  

Fed transparency can take many forms.  I have long argued that in nearly all cases however, Fed transparency works as an agent for only one side of the Fed’s dual mandate.  In nearly every instance I can imagine, Fed guidance acts as a support to growth.  Even in instances where guidance is directed toward advising of tighter forthcoming monetary conditions or policies, economic agents benefit from some removal of uncertainty. 

Transparency by the Fed has received a bad name of late and in nearly all official communications over the last three months, a ‘data dependent’ conditional reference toward monetary policy intent was explicitly stated.  In all fairness, the Fed has always operated under a ‘data dependant’ frame of reference.  Though in reality, that data dependency was at times pushed to a back burner and somewhat out of sight. 

Clearly the Fed wants to avoid a recurrence of the malinvestment it helped wrought when it engineered, between 2004-2006, a grave monetary policy blunder by advancing to economic agents a specific roadmap to policy intent that extended well beyond their view of the economic horizon.  It is very unlikely we will anytime soon see this mistake repeated.  At the same time, the Fed should be careful not to discard a valuable monetary policy tool just because it was once misused. 

I would argue that it is not time to jettison communicational support in the form of policy guidance just yet.  Clearly if and when the economy gains traction, say in the form of successive quarterly real domestic growth figures in excess of 2.1%, the Fed could throttle back on communications support and let a decline in pampered communication act to increase the level of vigilance on the part of risk-taking enterprise. 

One of the most interesting attempts at expectations management we have seen in quite a while happened only weeks ago when Fed Chair Yellen answered a question following her December 2nd appearance in front of the Economic Club of Washington when she discussed ‘The Economic Outlook and Monetary Policy  monetary policy.  In attending to the prospects for forthcoming policy initiatives, she extolled the virtues of the ‘dot plot’ (outlook for policy rates over next three successive years and the longer-run equilibrium level described in the quarterly Summary of Economic Projections (SEP)) for anyone looking to better understand the likely path for policy rates as being only gradually and modestly higher. 

You may remember, as I do, when Fed Chair Yellen earlier this year cautioning against reading too much into the ‘dot plot’ and that the Statement released following the FOMC meeting was intended to provide any needed information concerning policy intent going forward.  There must be a reason Chair Yellen drew attention to the ‘dot plot’ in front of this meeting. 

Fast forward to the upcoming FOMC statement, the SEP and the post-FOMC meeting press conference; We should expect that the December SEP ‘dot plot’ indicates a lower trajectory for the policy path than described in the earlier released September FOMC update and the longer run equilibrium level of fed funds too is expected to be lower than earlier projected.  Specifically, we might expect an eighth to a quarter point removed from each of the year end projections and a quarter point removed from the longer run equilibrium fed funds rate from 3.5% to 3.25%.  Some Fed watchers expect the Fed may even lower the longer-run equilibrium rate toward 3%. 

I caution against misinterpreting the meaning of SEP values and that they are intended to demonstrate each individual member’s expected values based on monetary policy being conducted in a manner they themselves believe most appropriate.  Clearly we cannot imagine that each individual within the FOMC has similar views on the appropriate course of monetary policy and thus, a collection of their individual expectations does not lead to an extremely robust or meaningful value.  However, it is better than nothing.

Should the Fed decide to raise the policy rate at the December 2015 FOMC meeting, as I expect and as is widely expected by a majority of Fed watchers and economists, then this forthcoming SEP report could be the last chance for participants to lower their expectations for the longer run equilibrium rate.  After the first instance of policy rate normalization, it makes less sense to continue to reduce the longer run equilibrium rate.  If that longer run rate has not stabilized by then, the Fed would more likely refrain from further rate hikes and review their assumptions to see what has changed that they had not earlier anticipated.  

Lowering the longer run equilibrium again, something widely expected, could ‘soften’ the impact from a shift in policy from accommodative toward neutral.  In the absence of a decline in the projection of the longer run equilibrium rate however, even if the projection for forthcoming year end(s) rates are lowered, sellers might become aggressive in back month Eurodollar futures and intermediate term treasuries. 

In Monitoring Normalization Progress:

We shall want to keep close watch on the ‘take up’ of any policy shift.  In that I mean we will want to take note of how much effort the Federal Reserve Bank of New York (FRBNY) Market Desk needs to exert in order to guide fed funds toward the middle of the policy corridor.  The easier it is for the Fed to direct policy rates higher, given the extraordinary level of excess reserves, the less incentive the Fed will have to jettison its bloated Federal Reserve System Open Market Account (SOMA) portfolio of securities.  The longer the timeframe expected for the Fed to hold those securities, all else equal, the greater the effort required of the policy rate in removing unneeded or unwanted levels of accommodation. 

Another topic I would like to touch on is ‘term premium’.  Currently the term premium for 10 year Treasury notes is near zero, coming from -0.41% in January. 1 The Fed will be watching the term premium rather closely with concern that long end rates might jump higher on the back of elevating term premium.  One of the areas believed to be helping to hold down term premium is the low level of projected inflation which may be bleeding over into the term premium calculations.  Additionally, lower European long rates are believed to have some cross border effect on term premium here. 

During the period 2004-2006, concurrent with exaggerated monetary policy forward guidance provided during the ‘restrictive policy’ initiative, term premium collapsed.  So while the Fed is concerned that rising term premium might signal a potential jump in long rates, they are also concerned that a term premium that remains too low could be signaling that economic agents are too confident that the Fed is on a pre-determined policy path.  Of course, the implication for this is exaggerated risk taking in the face of still higher policy rates. 

We are entering a most exciting time of monetary policy development.  Even if it were not for the divergence in policy activities between other G7 nations, the challenges facing the Fed in proscribing the appropriate monetary policy going forward is great.  They have to adopt to a lower trajectory for economic growth while recovering from a placid inflationary environment.  They are burdened by the baggage of policy errors in the mid-2000’s that they need to overcome.  Finally, they will want to plot a reasonable course that allows them to shed a sizeable SOMA balance sheet. 

As we move from a period of accommodation to a neutral policy stance, there will be continued volatility and overreaction to economic and monetary policy developments.  Importantly, there will be clues along the way that will help guide not only appropriate monetary policy, but also for us to understand likely changes in interest rates across the curve, growing or diminishing credit concerns and directionality on a number of asset classes. 

Finally, we will be allowed to cross the street without the Fed holding our hand; Just keep a keen eye on traffic.       

1.   Yellen’s Focus on Term Premium Getting Noticed in Bond Market

Friday, October 23, 2015

FOMC Report October 27-28, 2015; Leave the Door Open

Leave the Door Open

There is little reason to expect the Fed will adjust its policy rate at this October FOMC meeting.  If economic output since the September FOMC meeting had been slightly more robust and if the late-August financial markets disruption had more immediately and fully repaired, the October FOMC meeting would have presented a good opportunity for the Fed to begin removing monetary policy accommodation.  As it is, Fed officials are likely to collectively assume there is more to be gained from assessing for a bit longer the potential fallout from slower global growth and a possible step-down in the pace of domestic job growth.

While the markets are currently pricing a greater chance for monetary policy normalization to begin in 2016, my analysis still suggests the December meeting is a better likelihood.  Before the December, 2013 FOMC meeting few, for a variety of reasons, believed the Fed would change its stance on security purchases.  I argued before that meeting that the Fed would announce a reduction of purchases to begin in January (2014), describing a pace for the elimination of purchases by the 4th quarter 2014 (FOMC Report December 17-18, 2013).  Market participants may again be mistakenly expecting that the Fed will wait till ‘next year’ to move forward.

However, at the September FOMC meeting just past, a large majority of FOMC participants (13 of 17) indicated that they expected the policy rate to be higher at year-end.  While employment growth has continued, though at a slower pace – possibly as a result of some slack already having been removed from the labor market, other signs of moderation are expected to keep a majority of voters from electing to move in October. 

A reduction in output has been accompanied by a reduction in inventory levels that may prompt some re-shelving of inventories in Q4, elevating growth above potential once again.  Otherwise, the housing market continues to improve and consumer spending has held up well. 

In describing economic growth in the statement following the meeting, the Fed may choose to indicate that the pace has been ‘modest’ rather than ‘moderate’ as they had in September.  I suspect they will choose to continue to use the ‘moderate’ description and possibly note that the slowing in employment growth is consistent with the removal of slack in labor markets thus far and that the cumulative improvement has been encouraging.  Otherwise, the use of the term ‘modest’ to describe growth might suggest there is a lesser chance for a December policy response.  The Fed looses nothing in keeping its options open for December.    

In further acknowledging the cumulative gains in labor market conditions, the Fed might change their guidance language.  Instead of indicating ‘when it has seen some further improvement in the labor market…’, it may adjust to ‘when it sees continued improvement in the labor market…’  This does not change the intent of the guidance, but it could allow for some take-up from an otherwise disappointing note on lackluster global demand.  Leaving the door open for a policy response this year, the Feds job of readying economic agents in December, if the data warrants, would be easier if the Fed does not overemphasize the implications of still adjusting global conditions.  

Friday, September 11, 2015

FOMC Report September 16-17, 2015; Remove Accommodation or Leave Uncertainty

Remove Accommodation or Leave Uncertainty

In the grand scheme of things the Fed will not cause too many ripples on the cosmic screen of economic life by moving forward with monetary policy normalization at this (September 2015) FOMC meeting or by delaying that move.  The Fed has readied economic agents for the possibility for a policy adjustment at this meeting, but have become more cautious in the face of recent market unrest, a strong dollar and steady but below mandated inflation levels. 

For guide, my analysis suggests a greater likelihood for an October rate hike than for one in September.  Though I would not be as concerned by recent market movements and slow to respond inflation, I suspect enough FOMC members will be disposed to postpone a rate move.       

Many believe that this FOMC meeting is setting up to be the most contentious in years and that Fed members will have a heated debate.  Yet market participants have done little to price the outcome as an even bet.  Instead, Fed Fund futures indicate that roughly a 25-30% chance for 25 basis point target-range shift is priced.

Why Fed Should Raise Rates In September

Possibly the strongest argument for raising the fed funds rate at the September meeting is that it would move the Fed away from an inert state.  Monetary policy at a steady state too long can become stale and allow indecision to creep in.  Monetary policy on hold with as much accommodation provided as is currently the case has brought about a heightened level of market unrest as the consequence of the uncertainty that situation fosters.

Uncertainty about monetary policy direction has likely elevated the market reaction to recognition of a step down in the rate of growth in China.  By moving forward with a policy rate adjustment, the Fed will exit the ‘valley of volatility’ that exists between monetary policy regimes.  We can discuss further the benefits from ‘policy path awareness’ in a bit, but for now we will propose that once the Fed moves from inaction to guarded and modest firming action, a measure of uncertainty as relates to policy intent will be removed and this will likely promote more stable markets.  That stability will engender better economic growth prospects. 

An additional benefit from raising policy rates in September, while there is a less than unanimous expectations for such a move, is that the long end of the Treasury curve might react positively to what would appear to some as an ‘aggressive move’.  If the Fed waits until a rate move is fully priced in the front end of the yield curve, it may make a bullish response from longer-dated Treasuries less likely.  

Grave concerns have been expressed that movement toward normalizing policy rates will bring forth a major correction, along ‘taper tantrum’ lines, in the bond market.  A policy adjustment earlier than a majority suspects would give reason to some to suspect the Fed will need to eventually reverse course and lower policy rates again.  Under this assumption, longer-dated Treasuries yields may move lower, all else equal, and be supportive of growth.

 Why Fed Shouldn’t Raise Rates in September

The most compelling reason for not raising policy rates at the September meeting is that inflation has not shown enough progress toward mandated goals.  While recent oil price weakness and dollar strength may only bring transitory pressure on inflation, the level of confidence held by Fed officials for the return to mandated inflation levels could be much greater.  Additionally, the market turmoil in late-August is recent enough that a negative surprise from the Fed might set off additional market dislocation.  There is too of course, the argument that asymmetric risk attends raising policy rates too early rather than too late.  Finally, as earlier noted, the market has not fully priced a hike and though the Fed has been distancing itself from the notion of ‘transparent’ policy action, they are not yet at a stage where a surprise in policy implementation works to the advantage of policy intent.   

Financial conditions have tightened somewhat since the July FOMC meeting when there was greater confidence that the Fed would hike in September.  Some of the tightening in financial conditions is the result of a stronger trade-weighted dollar value that goes hand in hand with the stronger U.S. domestic economic conditions.  Modest policy rate increase expectations also support a strong dollar contribution to tighter conditions.  Importantly, some tightening in financial conditions is the result of recent weakness and volatility in equity and commodity prices. 

We have long argued that heightened volatility should be expected to accompany the period between monetary policy regimes.  While it is easy enough to understand that economic agents benefit from and take greater risk when they know the Fed is on a determined path to ease financial conditions, it is less clear to some that the same ‘path’ attributes in a restrictive monetary policy directive can be equally beneficial and supportive of risk taking.  Uncertainty in the direction of Fed policy intent is upsetting and has contributed to market volatility.  Less upsetting would be a policy path toward normalization, no matter how minimal its beginnings and no matter how elongated the timing to terminal value.  

Policy Quirk

While the Fed does not want to commit to a strict plan of policy action, it faces continued market volatility.  This volatility reduces risk taking, much of which is constructive given the current modest level of growth.   The Federal Reserve has taken great pains to insure economic agents understand they want to ‘normalize’ policy rates at a very gradual pace within a ‘data dependent’ frame of reference.  That means that while the Fed must always be forward looking, the guidance for adjustments in monetary policy will be the nature and the trend in data. 

Admittedly, an intention to normalize policy in a data dependent fashion with a ‘governor’ of gradualism is a difficult conditional framework to achieve.  It can only really be accomplished if the interpretation of incoming data suggest accommodation be removed at an already prescribed gradual pace. 

There is obvious contradiction to proclaiming a ‘data-dependent’ decision model while ascribing to a gradualism toward normalizing policy.  However, the Fed has awoken to the danger of too much policy transparency in a recovering economy.  A gradual move toward normalized policy implies a policy path while a data dependent guidance means policy choice is purely opportunistic. 

October Rate Hike

Even before the mid-August market volatility, it has been appropriate to consider an alternative to a September policy initiative.  For most economists, that meant either a December response or a 2016 start.  The Fed couldn’t very well say back in March that they were going to be ‘data dependent’, though only allow for the possibility of a policy response every other meeting – at the quarterly meetings that accompanied post-meeting public conferences.  Instead, the Fed needed to indicate that ‘every meeting was live’.  And while there was little reason at that time to be concerned that the data might not stack up nicely to allow for the first rate move to coincide with a quarterly meeting; it is starting to shape up as a distinct possibility the Fed will move at an ‘off-cycle’ meeting. 

There is good debate on how the Fed will proceed at the September meeting.  If the FOMC confab determines that it was a close call for a September move and only a minor difference in the data series would have provided a convincing argument, then we should expect a strong chance for an October FOMC meeting response.  Otherwise, if the Fed indicates at the September meeting that recent market volatility made postponing a rate rise the safe choice, then we might even more make ready for an October response. 

In order for the initial policy response to be expected only as soon as December or later, the Fed would need to indicate that the slack in employment is much greater than they had previously imagined.