Tuesday, March 20, 2018

FOMC Report March 20-21, 2018

Executive Summary
The Fed is expected to raise the fed funds policy rate by 25 basis points to a target range of 1.5-1.75% at this FOMC meeting.  Further, the FOMC statement is expected to again indicate that ‘the labor market has continued to strengthen and that economic activity has been rising at a solid rate.’  Additionally, we expect the Fed to advise that ‘near-term risks to the economic outlook appear roughly balanced’. 

The statement, the press conference and the reply to questions thereafter are all likely to be slightly more hawkish than is the Survey of Economic Projections (SEP).  In short, the Fed will allow the market, if it chooses, to start pricing the prospects for 4 rate hikes this year, but it will not push it to do so.  The Fed is not expected to plot more than 3 dots for 2018 on the SEP.  The Fed is instead expected to show 3 dots for 2018 and 3 dots for 2019 (from 3 & 2). 

Further Gradual   
Over the last few years the Federal Reserve has provided a rather straight forward view of the path for monetary policy.  The prevailing catch phrase used to describe policy implementation has been ‘gradual pace’ of accommodation removal, which dates to the December 2015 FOMC meeting.  Currently, gradual pace is widely believed to mean three, 25 basis point policy rate hikes a year. 

At the January FOMC meeting, the Fed added the word ‘further’ in front of ‘gradual pace’ in describing the course for monetary policy.  This caused a lot of excitement.  There remains some uncertainty as to whether the ‘further’ implied a step-up in the pace of accommodation removal or that the current pace of policy firming might be expected to last longer than earlier imagined.  For now, I’m leaning toward the latter interpretation.  This in part, is why the Fed is expected to adjust the 2019 dots from 2 to 3 rate hikes.  

Path to Data Dependent Risk
As the Fed adjusts to incoming data and judges the progress on the attainment of their dual mandate goals they will inevitably need to square with the notion that they cannot provide as much guidance as had been previously allowed.  One of the greatest benefits to being in the middle ground of monetary policy cycles is that it allows the Fed an opportunity to provide extensive guidance.  During mid-cycle the Fed can indicate a ‘path dependent’ approach to monetary policy implementation.  We may be pushing against the later edge of this mid-cycle monetary policy phase. 

At some point, the Fed will be required to react to growth beyond potential, inflation above its objective or excessive leverage which has caused great distortion to asset prices.  As this happens, the Fed will be forced to move to a data dependent regime and thus become 0unable to offer the guidance it once could.  Market volatility rises as the Fed moves to a data dependent regime while the ‘time lag’ between policy initiation and its effect on the economy collapses. 

As we saw in late-2016, once the Fed moved away from its ‘measured pace’ (aka ‘gradual pace’) to a data dependent mode of operation, the time lag for the earlier rate hikes narrowed and became at once a powerful drag on economic growth.  Currently, the Fed is toying with the catch phrase ‘gradual pace’.  If economic agents come to expect the Fed is moving away from a path dependent frame of operation to a data dependent and reactive approach, there will be great changes afoot.   We would of course expect greater volatility under less Fed handholding.         

Tuesday, January 30, 2018

FOMC Report January 30-31, 2018

Based on current conditions, we might expect historians to write favorably of Janet Yellen’s tenure as Chair of the Federal Reserve which comes to an end shortly after this meeting.  Yellen was handed the reins immediately following the announcement for the reduction in the scheduled purchase pace for the third in a series of quantitative easing programs which had eventually brought the size of Fed balance sheet toward $4.5 trillion. 

During her time, the Fed has been able to move the fed funds policy rate above the successfully defended zero-bound five times, to its current target range of 1.25-1.5%.  The last rate hike or what the Fed has preferred thus far to view as a ‘reduction in accommodation’ was conducted in December.  That December 2017 adjustment was the third such of the year which brought the policy rate in line with the Fed’s own late-2016 stated expectation (SEC dot plot) for year-end policy rate.  While the Fed had not always offered such a forecast, it is quite clear that the Fed had until last year, not been able to ‘guess’ a next-year-ending policy rate in more than a decade. That last time was of course when the Fed was finishing its ‘measured pace’ experiment.    

As indicated in my last FOMC report (‘FOMC Report December 12-13, 2017; Are We Again Seeing Malinvestement’), there is a little known or lesser appreciated risk in the Fed providing a somewhat predictable policy path for rates.  The nature of risk assumption is changed when a highly visible central bank policy prescription is viewed as and for a time proves to be extremely predictable.  Especially at historically low levels of interest rates, we should expect that the confidence built from a ‘known’ or perceived knowable policy path for rates will encourage leverage and speculation, even when that path for rates is higher. 
Since 2015 and the start of accommodation removal, financial conditions have actually gotten easier.  It is only recently that the move toward easier financial conditions has slowed.   A predictable pace of Fed policy path has contributed to this development.  Starting in October the Fed has added another policy path that is predictable.  The reduction in the Fed’s balance sheet is to be very gradual and is well defined.  While this policy path too adds to the known policy prescriptions, its influence on leverage and speculative interest is not expected to be that great.  Finally, the slow reduction in longer-date Treasury securities will not prove too much pressure on long bond yields as the Treasury is expected to make up the Feds absence mainly with Treasury bills and shorter maturity notes. 

The FOMC Statement   
The Fed is not expected to change the fed funds policy target rate from current 1.25-1.5%.  

The Statement may phase out references to hurricane-related fluctuations and note a strong (3.8%) increase in Q4 consumer spending, indicating more generally that economic activity continues to grow at a solid pace. 

Concern shown for below targeted inflation may be reduced as survey-based measures as well as underlying have recently improved. Still, the statement is likely to continue to advise that the Fed will ‘closely monitor(ing)’ inflation developments.    

The statement will likely still indicate Fed expectation for a ‘gradual adjustments in the stance of monetary policy’. 

The Fed could adjust the near-term risks statement from ‘roughly balanced’ to balanced, but to do so, they also risk a more complete pricing of the three rate hikes the most recent (December) SEP has called for this year.  Already, roughly 62 of the 75 basis points the ‘dot plot’ projects have been priced.  The Fed might not be in a terrible hurry to see the market out-price their projected path.

On Expectations and Surprises
Below is a chart that I have become fond of over the years as it has provided ample warning for conditions which indicate that too much or too little exuberance is afforded the prospects for US economic development.  The chart is of the Citibank Economic Surprise Index and it shows that from a low point in mid-2017 (negative 78.6), economists as a whole had regularly provided forecasts which were exceeded by actual output.  That trend continued until recently (See ‘Have Growth Expectations Gone Too Far?’) when in late-December, economists had apparently come full circle and began to believe the economy was doing better than it actually was.  You see that over the last month, the index has declined from 84.5, a high not reached since 2012, to 35.5 currently, indicating they have now regularly overestimated economic activity

While there is a growing acceptance that global growth is in sync and improving, underlying that improvement is an even greater anticipation for what is possible on economic output.  There appears to be some room for expectations to be curbed further.  Whether that results in a 'hiccup' in the move toward higher US Treasury yields is still to be seen.  Currently, attention is heavily focused on all things pointing toward a step-up in the pace for Fed accommodation removal and strengthening global economic output.




Tuesday, December 12, 2017

FOMC Report December 12-13, 2017; Are We Again Seeing Malinvestement

The Fed is very widely expected to raise its Fed Funds policy rate at this FOMC meeting for the first time since June and only the 5th time since June of 2006.  Two hikes thus far and after this meeting, three of the five (fifth projected) rate increases will have been made in December – showing restraint in removing accommodation. Still, some wonder if the Fed is not moving too quickly to fight a phantom inflation that never materializes.  Reacting only to the half-story which involves economic growth at a pace stronger than its ‘potential’ is a mistake, they say. 

Others argue too that projecting growth potential is a fool’s game.  Based on historic reference, there is no need to expect U.S. growth to be limited toward 2% annually.  Using forecasts of population growth and productivity rates to predict potential growth is nowhere near accurate enough to be of valuable in the prescription of monetary policy, they suggest. 

Some measure of sameness shows in the Senate and House versions of tax change bills that suggests some form of legislation will likely be enacted over the short term.  This legislation is projected to have a modest positive impact on nearby growth, even if short lived. 

Many Fed policy makers have indicated in the past that they had not factored any meaningful fiscal stimulus into their projections for growth, inflation, employment or appropriate policy rate path.  All else equal, it would argue for a strong discussion of the potential need for further policy response in 2018-2019, as long as the growth side of the growth/inflation picture remains emphasized.       

The growth side of the equation appears to be fairly well sorted at present with the global economy marking gains that should support U.S. growth.  Therefore, we might expect a greater FOMC meeting emphasis directed toward inflation, financial market stability and the potential for instability as the result changes to asset valuation.  No one likes to hear the word bubble attached to any asset they own, save those who have made a pile and have their finger on the sell button.  Otherwise, the prospects for overinflated asset prices have been directed lately at high value paintings, the equity markets and even Bitcoin.  The latter however has not been as directly tied to central bank largesse as has equity gains or high auction bids.  Some view gains in Bitcoin as a bubble.  Many of those who see a bubble concern themselves more with the human condition, than with too many dollars chasing too few bits.    

Policy and SEP Changes at this Meeting

The Fed will raise the Fed Funds policy rate by 25 bps to 1.25-1.5% range.  There will likely be a small add to the rate of growth expected next year (to 2.2-2.3% from 2.1%).  While there is a possibility for year-ending ’18 fed funds forecast to be revised higher to 2.4% from 2.1% forecasted in September, the chances are less than 50/50.  Otherwise, no change is expected for inflation prospects.

Implication for Current Policy Conditions

These changes will likely increase the perceived visibility of Fed policy path and lead to additional ‘risk-on’ trading, propelling additional gains in equities and other assets.  The value of fed guidance is diminished.  At this stage of the economic and Fed policy cycles, a widely understood path for monetary policy no longer provides benefit in the form of added incentive to engage in productive economic enterprise as it once did.  Instead, as was the case back in late 2015 and early 2016, the knowable Fed policy path is now simply pointing a spotlight on the hurdle rates as investors are further encouraged to accumulate assets that provide only speculative interest.  This condition is called malinvestement and is ultimately damaging to the foundation for strong sustainable growth.   

Fast approaching is the time where the longer run stability of financial markets would be helped by a less predictable Fed policy path.  There is enough definition to the path for the reduction in the Fed’s System Open Market Account to provide for some wanted guidance.  Over the period December to June, Fed officials should consider providing a lesser degree of rate guidance so as to allow greater uncertainty and thus limit malinvestement.  A gauge of Fed ability to pull back on telegraphing policy intent would be the variability of expectations for policy change surrounding FOMC meeting dates.    

Tuesday, October 31, 2017

FOMC Report November 1, 2017; What Could Derail Low Volatility

The least exciting of the eight FOMC meetings this year is upon us and scheduled to conclude on Wednesday November 1st with a statement that gives no surprises and is little changed from the prior FOMC statement.  Interest in this meeting is centered on its use in setting up for a policy response in December.  The Fed is overwhelmingly seen as concluding its projection for raising policy rates for a third time this year.  Absent a large economic surprise, the Fed is expected to raise policy rates at the December meeting.  Doing so, it will have for the first time since 2005, completed a year where it was able to follow its own prescribed policy path. 

Since 2005 – a year of uninterrupted ‘measured pace’, 25 basis point per meeting rate hikes, the Fed has been unable to correctly guess only one year ahead how its monetary policy would unfold.  To be sure, there has been many unforeseeable events over the last 12 years that temporarily altered the pace and nature of economic growth.  Until now it seemed it had become impossible for the Fed to engineer, in advance, a workable monetary policy framework for the upcoming year. 

It would appear as if congratulations are in order for the Fed having again, but only for the second time in 12 years, found their policy projections have lasted the year.  We must not however forget that it was in that remarkable time of monetary policy awareness between mid-2004 to mid-2006 where so many were drawn to complacency, excess and malinvestement.

There is something frighteningly magical about a knowable monetary policy path.  It works charmingly when it is of the easing variety and the temperature of economic conditions is cool.  However, when the economy is running a bit less cold, the dynamics of a known policy path are less overwhelmingly constructive.  As seen during the ‘measured pace’ experiment, a modestly ‘restrictive’ monetary policy path that is highly understood under conditions of excess accommodation is unlikely to deter malinvestement.  Volatility remains low for a time until it is determined that the Fed can no longer project a workable policy path and economic agents realize they no longer have faith in the lasting nature of economic performance or their capacity to handicap developments.     

A low volatility regime is consistent with a known monetary policy path during placid economic times.  In 2005, the VIX index finished the year over 20% lower than where it started the year.  Not until earlier this year, just before the Fed executed a second expected quarterly rate hike in June did the VIX trade again at the low levels seen in 2005-2006.  As long as economic conditions remain modestly constructive, we can imagine that a generally well understood, gradual path of accommodation removal will be well received.  However, when at some point economic agents come to see the Feds policy path as less knowable, either by reason of economic conditions overheating or excessive cooling; tranquility as described by low volatility measures will become absent.  That could be a very scary Halloween story.  

Within the FOMC statement look for the Fed to upgrade business investment from “picked up in recent quarters” to something like “shows continuing strength”.  Look also for indication that employment remains strong or “is strengthening”, for global economic conditions to have improved and acknowledgement that hurricane disruptions are lessening.  Finally, expect recognition that inflation remains below target, but that current conditions will not prevent a rate response in December.