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.      


Monday, July 27, 2015

FOMC Report July 28-29, 2015; Transparency Gets Cozy with Data Dependence

There is little reason to think the Fed will surprise with a policy firming at the July FOMC meeting.  Virtually everyone expects they will pass until September at the earliest, though a majority does expect a September start to monetary policy ‘normalization’.  The question being asked is ‘how obvious does the Fed need to be in signaling its first policy rate firming in more than a decade?

It may be enough that a majority currently believes that the Fed will reduce policy accommodation in September.  However, the Fed might want a stronger majority to understand its intention and so thwart any unwanted volatility.      

Data Dependent Does Not Mean Secrecy

The Fed need not collect every last bit of available data prior to meetings before deciding if the timing is right to normalize monetary policy.  Clearly there is a trade-off however between certainty and timeliness; The longer the Fed waits, the more confident they can become that they should (shouldn’t) have normalized earlier.  But that is driving by using the rearview mirror.  They can never know with certainty today that a policy move will prove correct.  What they can do is rely on the progress of data and make assumptions.  In the end, that is all that can be expected.  

Data dependency and transparency are not mutually exclusive.  The Fed can be data dependent and give ample guidance that a policy firming is forthcoming.  The Fed may have already collected enough information to be confident that a policy firming in September is appropriate.  If the Fed is relatively comfortable that enough quality data has been collected in order to decide that a September ‘lift-off’ is appropriate, then they would not gain by making economic agents guess what their intentions were. 

The benefit derived from Fed transparency should out way the cost of taking flack from those who would argue that the Fed had abandoned its ‘data dependent’ promise.  Market participants need not assume the Fed has discarded data dependency as a guide.  The Fed can make clear that it expects data to conform.    

Dana Saporta at Credit Suisse offered a smart way for the Fed to advance its data dependent interests while making a stronger case for the Fed to move in September; "If economic activity unfolds as expected, it may become appropriate to diminish slightly the very high degree of accommodation currently in place.”  Even stronger, the Fed could say “If economic activity unfolds as expected, it ‘would’ become appropriate to diminish…”

In Summary

A large majority already expect the Fed to adjust its main policy rate at the September FOMC meeting.  Unless the Fed has good reason to postpone that move until December (or later), it would benefit from providing additional clarity about its intentions at the conclusion of the July FOMC meeting.  In doing so, the Fed would not be abandoning its stated intention of being data dependent, but would help to facilitate the adjustment with added transparency during this transition period.     

Tuesday, June 16, 2015

FOMC Report June 16-17, 2015; Fed Coming Late to Party

Nearly Three Years of Policy Visibility

The Fed has added to its stores of creditability by maintaining its policy rate at a long-promised artificially low level through midyear-2015.  However, it will be paying back from those supplies if it should remain sidelined much longer while employment and inflation continue to repair.  

At an FOMC meeting in September 2012, the Fed made a last adjustment to its dated-based policy guidance, saying; ‘exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.’  While that last date-based policy guidance lasted only until December of that year before the Fed adopted ‘threshold’-based guidance, the Fed advised at that time; ‘The Committee views these thresholds as consistent with its earlier date-based guidance.’  Any change to policy guidance since has included a reference that the change does not alter the intent of the prior guidance message.  In a way then the dated guidance of ‘at least through mid-2015’ still stands.

Since the September 2012 FOMC meeting and before, expectations for above trend growth have been followed by consistent and cumulative declines in the potential output expectations.  Back in late 2012, the Fed thought the longer run growth potential for real GDP was 2.3-2.5%.  At the March FOMC meeting earlier this year the Summary of Economic Projections (SEP) reported longer run growth prospects were believed to be only 2.0-2.3%. 

Some argue that because of this reduction in expectations for potential output, the Fed has greater leeway to firm its policy stance under slower than once assumed growth conditions.  If correct in assuming the potential growth is as low as 2.0-2.3%, Fed officials must also be prepared to accept that they were, for a time, running a more accommodative policy stance then they had earlier imagined. 

Unfortunately perhaps, the outflow of that greater than intended level of accommodation has not to date brought about consistently above trend growth levels.  And while current year over year and projected growth over the next year are considered by the Fed to be above trend relative to latest SEP, there has been no meaningful rise in inflation thus far.  It is likely therefore that either potential growth is higher than the Fed’s 2.0-2.3% longer run expectation or that there are latent but building inflationary pressures.  At this juncture however, with the fresh memory of weak Q1 growth, a greater majority would instead highlight the fact that despite higher than anticipated levels of monetary policy accommodation over the last years, neither growth nor inflation has yet achieved critical levels.      

It is difficult to remain encouraged by the additional repairs to household balance sheets and to the abundance of cash on balance with businesses.  These strong positions suggest the ability to generate invigorated spending and investment levels, thus raising growth and employment conditions.  A late arrival of the beneficial impact from improved balance sheet conditions however, may find their eventual appearance a surprising event and not without some positive adjustment to growth, employment inflation expectations.

Illiquidity Concerns

There has been considerable and likely exaggerated concern about the prospects for a spike in long rates following a Fed announced rise in the fed funds policy rate.  Many point to the mid-2013 ‘Taper Tantrum’ as reason to be concerned.  Others, more correctly recognize the reduced presence of bank positioning as a likely contributor to future periods of market illiquidity. 

We should remember that when then Fed Chairman Bernanke spoke of removing the securities purchase program in mid-‘13, he did not indicated any ‘policy-path’ for that accomplishment.  As a result, confusion and concern brought about by that unknown led to an exaggerated reaction.  Note that when the Fed in December of that year laid plans for a ‘program’ of steady reduction to that purchase program, the reaction to the news was minimal. 

On the approach of the first policy rate adjustment in more than 6.5 years, the Fed has made clear that the process of removing accommodation should be expected to be abnormally slow.  This assurance will help to limit the reaction to the initiating of the firming of the policy rate.  Although the Fed is not providing exacting detail for the timing and measurement of accommodation removal as it attends to its ‘data-dependent’ approach, we have been given strong assurances that no abrupt policy firming should be expected in the near-term. 

An articulated ‘policy-path’ for the tapering of security purchases helped to prevent an over-reaction to a tempering of additional accommodation back in 2014 (For further discussion on ‘policy-path’ see (  At present, the long-standing Fed assurances that ‘even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run’, should prove supportive once the Fed begins raising the fed funds policy rate.

Until more recently, I had expected the Fed to move forth with its initial reduction in monetary policy accommodation by raising the fed funds policy rate at this June FOMC meeting.  While, I still believe that to be the best policy decision, the recurring distraction from another single winter quarter of weak GDP however has likely contributed at least an additional modicum of caution on the part of FOMC participants that will leave them prepared to postpone the initiation of policy rate firming. 

We advise listening carefully to clues that would place the July meeting more squarely on the table for the first policy rate move.  This is the main risk that attends this meeting.  The market has priced less than 2 policy rate firming (of 25 bps per) for this year.  Should market participants come to give greater expectation to a July start for policy firming, the front end of the yield curve could have a significant adjustment.  At the same time, we would ready in the event there is an excessive over-reaction out the curve to such news as this would provide additional positioning opportunity.

Finally, some economic agents have become sensitive to the reduced level of liquidity in the fixed income markets as Basel III initiatives have caused banks to scale back participation.  As a likely offset to this reduced bank participation, we should expect that the initiation of reduction in accommodation, will itself provide some benefit from increased policy transparency.  Currently with policy neither increasingly more accommodative nor reducing the level of accommodation, economic agents are less willing to move forward with spending and investment plans until such time as a more confident assessment can be made about the future for policy rates.

Counter-intuitively, even a small move forward in the process of policy firming could provide a boost to economic growth as economic agents become more confident in their assessment of future policy rates.  Especially at current low levels of policy rates, a greater conviction on the part of economic agents in their ability to forecast forward rates should be expected to outweigh the impact from marginally higher policy rates. 

At This Meeting
  • 2015 GDP growth likely to be lowered from 2.3%-2.7% in SEP
  • Current economic outlook to be upgraded in Statement
  • Expect more forceful acknowledgement that ‘Every Meeting is Live’
  • SEP 2015 Year-End fed funds still 0.63%