Tuesday, December 16, 2014

Guidance for mid-2015 Policy Move to Provide Stability

Guidance for mid-2015 Policy Move to Provide Stability

A small risk remains for disinflationary pressures.  However, the scale is tilted so marginally at present that it should tip toward excess growth and inflationary pressures at anytime.  The oil shock which shall be transitory will not have a lasting grip on inflation.  In fact, the lower oil prices today may in a short time serve to boost inflation expectations again as generally rising energy prices equate to rising inflation expectations.    

I shall keep the discussion about specific changes to policy prescription for this meeting to a minimum (see bullet points below) as I believe a strong majority have a good handle on that outcome.  Instead, we will review the nature of volatility as it relates to shifts in monetary policy paths from accommodative to less accommodating.    

Regular readers here will remember that we have advanced the notion that the Fed would not discard the ‘considerable time’ language until it was rendered meaningless and throwing off an odor similar to that from a long dead rodent under a back deck. 

It is not so much that a policy rate move is necessarily so nearby that renders ‘considerable time’ less useful – though such a move is nearby.  Instead, rather than providing economic agents additional confidence in the form of a longer period of knowable policy path as it once did, ‘considerable time’ has become a distraction to economic growth in that it attracts attention to the uncertainty surrounding the shifting policy stance.   

Consider briefly the four monetary policy transitions during a regular policy cycle: Easy to Neutral, Neutral to Tighter, Tight to Neutral and finally Neutral to Easing.  The transition from Easy to Neutral (accommodative to less accommodative) monetary policy is the part of the Fed cycle that affords the most risk.  Said differently, this is the part of the Fed’s policy cycle that rightly requires the most data dependency.  Especially at the zero-bound, the Fed wants to get the timing right.  An aborted policy transition here could prompt a long period of policy uncertainty and result, all else equal, in lower levels of risk assumption and viable productivity investment. 

‘Considerable time’ language fails to provide any stability as regards an understanding of the likely policy path and thus is expected to be removed at the December meeting.  ‘Considerable time’ was rendered nearly useless following the addendum attached at the last FOMC meeting noting that a policy response could come either sooner or later should data unexpectedly shifts in either direction. 

We had come to expect that the nearness to a policy shift, still expected in mid-2015 would create more volatile markets and we have seen as much in equities, interest rates and commodities, most particularly oil of late.  The VIX index sports a 50 day moving average that is higher than any since January 2013 at 15.8.  The Move (Merrill Lynch 1-month Implied Treasury Volatility Index) 50 day moving average is higher than any since December of last year.  These indexes help to demonstrate the heightened uncertainty surrounding upcoming but still less definitive monetary policy shift.      

Market calm generally experienced over the last few years has allowed households and business to repair their balance sheets, even though thus far there has been less than hoped for consumer spending and business investment.  Market calm was brought about in part by the strong conviction economic agents had in their clear understanding of where short term rates would be over a longer timeframe.  Greater calm induced by policy path certainty brought about a stronger economic response than seen earlier in the financial crisis. 

The point of policy flux from increasing to decreasing levels of accommodation is now near enough that the visibility or confidence level surrounding expectations for policy path and available liquidity have diminishes.  This tempers an overall willingness to assume risk. As such, pockets where an abundance of investment was earlier directed can be found extended and subject to liquidity constraints. 

This may be helpful in understanding the current oil shock and repercussions for other markets.  Attractive borrowing rates and extraordinary liquidity may have prompted a greater than currently sustainable flow of funds toward shale oil discovery, extraction and transportation.  This condition, like housing in the mid-2000’s reached beyond the physical markets and into credit standards and types of financial instruments used to finance such operations.  As long as the underlying asset, then housing and today arguably oil, were expected to command stable to growing prices, the willingness of lenders to make funds available was strong. 

One might argue that the housing bubble of mid-2000’s and today’s oil shock are entirely different in that the housing bubble happened during a period where the Fed was removing accommodation, whereas today the Fed has held policy rates near zero for 6 years.  How can the repercussions of excessive leverage and malinvestment in the housing market a decade ago compare with the investment in energy production and today’s oil shock?  Does this mean that the Fed cannot proceed with accommodation removal because the recovery has been jeopardized by a well articulated policy rate path over the last 6 years? 

To the first question, we might recognize that the housing bubble and subsequent dislocation as well as what some are now calling the shale bubble were both born out of very predictable Fed monetary policy regimes (paths).  It is not so important that policy rates in 2004-2006 were higher than rates today.  Instead, we should concentrate on the fact that the path for policy rates was as predictable then as they have been for some time now.  It is not so much that rates are today near zero, as that moving them prompts dislocation.  Near zero policy rates were once predictable across a great swath of the policy path timeline and are no longer as knowable.  Then as now, the confidence held by economic agents in their understanding of the path for policy rates became diminished.  Currently the debate rages about when the Fed will first raise the policy rate and by how much that rate will rise through time. 

In contrast, when the Fed in 2006 chose to discontinue the path toward successive, marginal and completely telegraphed 25 basis point policy rate increases, it short-circuited a most dependable policy path.  Economic agents had so relied on the nature and predictability of that policy path that the longstanding time lag between policy initiative and the effects felt on the economy had become grossly stretched.  By the time the Fed exited the policy path of 25 basis points, per meeting of policy rate firming, the build-up of malinvestment was great.  The snapback from an elongated time lag between policy initiative and its effects on the economy was extreme.  All at once, the effect of those marginal rate increases came to bear on the economy.  Forestalled by the nature of policy guidance, the absence of that guidance compressed that lagged effect.   

Today, the Fed is moving closer to changing policy.  The Fed is rightly becoming more confident in the need for a policy shift not because of excessive malinvestment and accompanying systematic risk, though there is a healthy concern and attention focused in that direction.  Instead, a majority of Fed officials have become increasingly confident that the economy shows strong enough signs of stable growth that the slack in resource allocation will further diminish.  The urgency felt for this course of action toward higher rates is tempered by only slow and uneven increase in inflation thus far. 

The predictability of the Fed policy rate path had until recently been very clear for years.  The Fed told us as far back as September 2012 at the FOMC meeting that policy rates were likely to remain low until at least mid-2015.  At that same meeting they introduced ‘considerable time’ to describe a period for which a highly accommodative monetary policy stance would be appropriate following the strengthening of the economic recovery.  They have consistently used this phrase since.  This guidance has of course offered, until recently, a strong confidence in the likely path for policy rates.  

Mid-2015 is the most widely expected launch date for policy initiative more than 2 years later. Economic agents found that policy rate timeline understanding very supportive and it gave them a greater willingness to take on risk.  Were it not for a wide output gap and rolling concerns that the economy might slip back into a recession, these economic agents would have been more aggressive in their assumption of risk to take advantage of this condition.   

There were of course some areas where economic agents were sufficiently incentivized to make use of the understanding of steady state policy rates for a ‘considerable time’.  As a case in point, extraction costs of $60-$70 a barrel for shale oil, give or take $10 or so depending on a multitude of factors, against a price range of $75-115 since 2011 along with a confidence that the Fed would keep rates low until at least mid-2015 was incentive enough for many to get involved. 

Today, only 6 months away from mid-2015, economic agents are comically becoming more greatly aware that the path for policy rates is not sufficiently predictable.  They can rely on generally low rates over the coming year, but they cannot be as certain about the path for rates as they had been earlier this year.  This in large part is why oil fell as much as it did, why spreads between Treasuries and high yield securities have widened and why equity and commodity markets more generally have been volatile.

It is much easier to invest for the long term when one has great confidence in their understanding of financing costs or ‘hurdle rate’ for next two years.  This is what a path for policy rates can bring.  Whether those rates are steady, steadily declining or steadily increasing, a known path for policy rates is extremely supportive of economic activity when a large enough output gap exists and an agent for malinvestment when the gap is marginal.

When I was a boy scout I went to a camp that allowed us to shoot skeet with a buckshot 22.  I had limited success initially until I recognized that if I waited for the clay pigeon to break either right or left, I could more easily predict the path and place the shot in its expected path.  Right now, with respect to fed guidance, the pigeon is launched but it hasn’t broke in either direction; so we sit on our hands waiting for the break.      

The risk that extreme malinvestement, cause by extraordinary confidence in a known policy path over the last 5 years had of course been greatly tempered by the size of the output gap that existed.  The Fed is completely correct in providing all measures of support for economic growth during times of distress which create wide and unwanted gaps between economic potential and current conditions.  As those gaps disappear, the need for and danger in providing assurances in policy path for rates becomes greater. 

As the Fed moves from more to less accommodation provided, it will at least initially want to maintain as high a level of predictability about the policy rate and the use of other policy tools as possible.  In doing so, it will continue to provide support through communication and understandings for policy path which will soften the unavoidable uncertainty economic agents have around the policy shift. 

What the Fed should do eventually and where they got it wrong in the mid-2000’s, is to reduce guidance as the economy improves.  This may appear to some as irresponsible Fed behavior but it is not.  If high levels of monetary policy transparency are to accompany strong economic growth near full employment and minimal resource slack, the Fed will have to raise policy rates significantly more to counterbalance the support that policy transparency provides.  The Fed can begin to withdrawal some measure of active support through reducing policy guidance as economic agents gain confidence about sustainability strong economic conditions.  In effect, the support provided by a knowable policy path can be replaced by confidence in economic conditions.

Compared to the mid-2000’s, the Fed will have reason other than the level of rates to pare back its support through communications.  For a protracted period forthcoming, the risk for higher long term Treasury rates as economic progress is achieved is reduced by the lack of supply and Fed holdings of these securities.  Upward pressure on long term rates from rising term premium as a result of increased volatility in short term rates will be countered in part by the downward pressure on rates from the stock effect of the Fed’s portfolio. 

The Fed Understands the Significance of Policy Path

At a recent luncheon meeting on Monday December 8th, Atlanta Fed President Lockhart noted the danger in making the path for policy rates less easy to read.  With regard to the danger of ‘reversing a start to interest-rate normalization’ Lockhart indicated; ‘There would be real costs associated with an irresolute path of policy.’  More important than the concern Lockhart expressed for lost Fed’s creditability as the result of an aborted policy firming would be the disruption cause by a less understood Fed policy path.   Fed creditability aside, a break from a strongly anticipated path for policy rates from the zero bound would do damage to the level of risk economic agent would be willing to take for some time. 

The best way to avoid having to break an expected policy path from the zero bound is to postpone that adjustment until greater assurances can be made that a rate hike will not need to be reversed.  This is essentially the argument that Chicago Fed Evans has been making.  We should expect Fed officials are well aware of these conditions on the approach of policy rate lift-off and expect they will have waited sufficiently long enough to be reasonably sure they will avoid having to reverse a policy initiative.  There is a growing level of confidence both inside and outside the Fed that mid-2015 will allow sufficient time to recognize the stability and sustainability of economic growth. 

Pain in the form of higher volatility from increased levels of uncertainty surrounding a policy change from accommodation add to accommodation removal is already weighing upon the markets.  Following through with a longstanding expectation for an initial policy rate move in mid-2015 is the least painful way through current uncertainty.  On the other side of the first policy rate hike, where expectations for pace and duration of accommodation removal reside, another elongated period for understanding policy path waits.  The Fed would do well to get to the other side of the first policy move and return to heightened levels of certainty about the path for policy rates.  In doing so, the Fed will be closing the door on policy uncertainty and likely opening a huge can of ‘animal spirits’.    

An initiation of accommodation removal starting next year is clearly expected and largely supported by Fed officials in general.  Any artificial vagueness about likely policy firming plan could damage Fed creditability and add volatility to markets. If the Fed is predictable about the process of shifting from accommodative to a less accommodating policy stance, the potential level of market dislocation can be reduced. 

The clearest way to reduce dislocation at this point is to remove ‘considerable time’ and replace it with a reference about a willingness to be ‘patient’ in attending to accommodation removal as was done in 2004.  Economic agents know that script and that familiarity will lend stability to markets. 

A Thought for Tomorrow: Term Premium and Long Rates Then and Now

In 2004-2006 the reduction in short-term interest rate variance expected and realized around the policy rate path brought about extreme pressure on the term premium, helping to keep longer dated rates lower than they would otherwise have been.  If the stock effect of the Fed’s portfolio is expected to maintain downward pressure on long rates, the Fed might be required either to raise policy rates more quickly for a given level of sustainable growth above potential or reduce the level of supportive guidance about the path for policy rates.  The former would be expected and the latter would indicate lessons learned from the 2004-2006 ‘measured pace’ disaster.    

So as not to appear uncaring about details of policy prescription provided at this meeting, I would offer the following bullet points:
  • The Fed drops ‘considerable time’ and replaces with ‘patience’
  • The statement strengthens language about economic and job growth
  • Oil price declines are noted and recognized for having only transitory impact on inflation
  • Continued reinvestment of maturing securities and principal payments with no additional guidance given as yet
  • SEP dots roughly unchanged – possible small shift lower in fed funds rate projection 2015
  • SEP – small up-tic to real GDP ’15 and ’16
  • SEP – small down-tic to unemployment rate ’15 and ‘16
  • Q&E – Yellen to acknowledge some comfort and confidence in being able to move forward with policy shift

As an Aside: If someone wants to buy a used pick-up truck today, he would not look in Chicago where gasoline prices are suddenly lower, he looks in North Dakota where gasoline prices are suddenly lower, but also are the number of help wanted signs. 

Tuesday, October 28, 2014

FOMC Report - October 28-29, 2014; 'Taper-Tantrum to Successful Policy-Path Guidance'

Taper-Tantrum to Successful Policy-Path Guidance

Executive Summary

Recent market volatility in fixed income, equities, commodities and foreign exchange is largely the result of greater uncertainty surrounding the path for monetary policy, a situation that will not soon change.  A reduction in usable (visibility-aiding) Fed forward guidance accompanies the transition from ‘time’ to ‘data-dependent’ policy guidance.  Similar bouts of volatility are possible and even likely until a greater sense of confidence surrounds the timing of the first policy rate increase and its aftermath.     

The Fed will announce the end of the securities purchase program (QE3) as initially outlined at the December 2013 FOMC meeting.  The ‘considerable time’ language will remain without value adjustments. There is room for a slight and conditioned upgrade in the employment situation and an acknowledgement of moderation in inflationary pressures.  However, if these modest amendments are offered in the statement, they will be referenced such that no policy adjustment is implied.  Finally, and without consequence, the statement may note recent weaker global growth, reduction in energy prices or the recent market gyration.   

Current Eurodollar, Treasury and Fed Fund futures prices and their implied projections for an initial policy rate move in late 2015 as well as current market participant positioning, suggests the risk is for higher yields and for the statement to imply a less dovish Fed policy intent than currently priced in the market.    

Volatility and Visibility

Economic agents have become accustomed to a greater level of time-dependent policy guidance.  The recent spike in market volatility is an expected outgrowth of the reduction in visibility along the monetary policy prescription timeline.  While data dependency has forever been at the core of Fed policy intent, the construction of guidance, using calendar reference has heightened the confidence of economic agents for their forecasts on interest rates and other policy variable levels. 

The Fed has offered numerous ‘promises’ to maintain policy accommodation for specific periods or dates in the future.  The oldest and still valid time reference guidance was made in the September 2012 FOMC statement; ‘In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.’  So far, this statement has given accurate and visible guidance for more than 2 of its projected 2.75 years of Fed monetary policy timeline.  It is difficult to calculate the value of this support.  Its ongoing support however, aside from its creditability enhancement is certainly worth less today than it was in late 2012.         

Additionally, guidance afforded by the timely regular reduction and elimination of the securities purchase program known as QE3 is also coming to an end.  This program initiated as open-ended starting with agency mortgage-backed mortgage securities, advanced to include treasury purchases.  It is widely believed, despite St. Louis Fed President Bullard’s urging otherwise, the Fed will conclude the program with an announcement at this meeting.  The Fed has no good reason to disappoint in this regard. Some economists have not embraced the notion of the tapering of securities purchases as guidance even though they used this Feds guidance on the path for scaling the purchases in their macroeconomic forecasting models.       

Though the reduction in securities purchases from a level of $85 billion per month, begun in January 2014 resulted in gradually lesser amounts of additional stimulus provided, the known ‘policy-path’ timeline advance of those adjustments aided economic agents in their ability to project Treasury and spread rates based on that schedule.  To that extent therefore, the guidance provided by the stated intent of scheduled, discrete and calculable changes in the Feds securities purchase plans provided additional visibility along the Feds policy timeline. 

A much anticipated approach of the transition from increasing to decreasing levels of accommodation has begun.  The transition does not allow for the kind of Fed timeline guidance that provided support while policy goals were further from reach.  Timeline references such as ‘mid-2013’, ‘late-2014’ and ‘mid-2015’ have been replaced by ‘timeline-light’ references such as ‘considerable time’, ‘patience’, and ‘some time’.  Because of the strong possibility for additional disruptive market volatility on the approach of policy normalization as an outgrowth of reduced visibility, the Fed should be expected to continue to use ‘timeline-light’ references until its first policy rate hike.  

Though the continuation of vague calendar or time references about future policy intent will irk some Fed officials, a majority will be expected to carry forward this effort. Therefore, given the reduction in the visibility provided by Fed guidance in the loss of the policy-path tapering and the erosion of time to a mid-2015 policy rate adjustment, we should expect that despite some argument from both doves and hawks, the ‘considerable time’ language is likely to remain until at least December. 

Success of Policy-Path Tapering

There was no schedule, reference to process or time until completion offered in the May/June 2013 outburst(s) where then Fed Chairman Bernanke indicated the Fed would likely begin scaling back the level of securities purchases.  The latest efforts toward providing monetary policy support at the zero bound (QE3) had been categorically different from previous efforts because this latest program had no stated ending date or limit to the amount of securities eventually to be purchased in the program.  As such this program carried a stronger message that the Fed was willing to go to great lengths to insure its success.  Any signal or Fed conveyance of interest to end such a program needed to provide a level of detail commensurate with the importance of that program.  The lack of that detail offered in May/June ‘13 about the scaling back in securities purchases caused great concern and a dramatic jump in yields.

At the December 2013 FOMC meeting, the Fed outlined a program for reducing the monthly level of securities purchased by $10B and laid out a plan for ending the purchase program according to a schedule that would include regular and similar reductions in amounts purchased.  At that meeting the Fed indicated the $10B reduction starting in January would ‘modestly reduce the pace of its asset purchases’.  They also noted that if continued progress toward policy goals was achieved they would ‘likely reduce the pace of asset purchases in further measured steps at future meetings.’  By using ‘modest’ to describe the initial purchase reduction and by indicating ‘further measured steps’ for progress, the Fed outlined a detailed ‘policy-path’ for tapering.

Unlike mid-2013, the clear pronouncement of the schedule for eliminating the purchase program gave economic agents an advance preview of forthcoming Fed monetary policy timeline, providing anyone who chose, an opportunity to plot out a path for the winding down of the program, of course conditional on steady expected progress on policy goals.  Although the Fed was reducing the amount of additional monthly stimulus, it provided something in its place; visibility.  As such there was no adverse reaction as was witnessed in the mid-2013 ‘taper-tantrum’.  The Fed had succeeded by using its ability to add visibility to the monetary policy timeline, providing truly usable forward guidance. 

Fed Guidance Now

 The nature of Fed guidance is changing on the approach of normalization in monetary policy.  Timeline references become absent as we near the inevitable policy rate movement above the zero-bound.  Less definitive catchwords are used, such as the current ‘considerable time’ which many believe to include at least several FOMC meetings or nearly half a year.  This phrase, casually suggested to mean roughly 6 months when Fed Chair Yellen spoke at her first post-FOMC press conference, lost some of that clarity when Fed Governor Stanley Fischer more recently suggested it could mean anywhere from 2-12 months.    

The absence of timeline visibility in monetary policy on approach of transitioning from easy to less accommodative policy intent is naturally a period of angst.  By forwarding a schedule of intended steps for the process of normalization (‘Exit Plan’), the Fed adds back some level of certainty reduced by their inability to provide timeline or date dependent guidance on the policy rate. 

Further, the Fed will likely give some additional information about the timing and process for reducing and eliminating the reinvestment of its portfolio interest and principle receipts.  We should expect this guidance to be somewhat similar to the structure of the ‘policy-path’ for tapering.  The announcement of that process will provide some timeline policy visibility, offering support during a period of adjustment toward policy normalization.      

Of course the Fed’s post-FOMC meeting statement will continue to be a strong source of guidance, as will the Minutes and the Beige Book.  All of these regular opportunities for communication can provide a picture of policy stability and foresight, offering both financial and economic support. 

The most recent beige book made great efforts to paint a picture that conditions had not changed much at all since the last Beige Book was presented in front of the September FOMC meeting.  There were no fewer than seven instances, covering overall economic growth, consumer spending, employment and price pressures, where the pace of growth was indicated to have been consistent with the previous reporting period.  The message here is that we should not expect great change in either the statement or the current path for monetary policy despite recent short-lived market turmoil.   

Monday, September 15, 2014

FOMC Report; September 16-17, 2014

The Importance of Communication

The first order of business discussed in the Minutes from the last FOMC meeting in July was the formation of a ‘New Subcommittee on Communications’.  It seems reasonable therefore that we begin this report on that topic.  First, this subcommittee was appointed by Chair Yellen in the interim period between the June and July FOMC meetings.  It is possible therefore this subcommittee offered some input at the July FOMC meeting.  More likely however is that this subcommittee will give its first briefing at the September FOMC meeting or later. 

Secondly, little was noted in the press about the formation of this subcommittee, whose attention was likely diverted by the lengthy discourse on the business of monetary policy normalization also included in the Minutes of the July FOMC meeting.  In circles where monetary policy is discussed, policy normalization is currently a lot more ‘sexy’ then communication.   However, if the process of normalization is to be successful and at all smooth, it will require considerable linguistic agility. 

Finally, we should recognize the importance that Chair Yellen attaches to communication, quite likely furthered when, as then Vice-Chair she led the last subcommittee tasked to review this issue.  Recognizing the importance of this topic, I dedicated much of my last FOMC Report[i] to the analysis of her April 2013 speech ‘Communication in Monetary Policy’ which was instructive in learning her views on the normalization of monetary policy.  Communication in monetary policy, whether appreciated or scorned has become integrated as never before into the fabric of monetary policy implementation.  Chair Yellen, in her April ’13 speech[ii] indicated; ‘The FOMC had journeyed from "never explain" to a point where sometimes the explanation is the policy‘, leaving little doubt the importance she places on communication.  

Today’s most widely talked about Federal Reserve monetary policy issue is whether or not the Fed at this meeting will communicate its intentions for the policy rate using the now familiar term ‘considerable time’.  Intended or otherwise, within the decision process on the timing of policy rate lift-off, the term ‘considerable time’ has become a touchstone for Fed policy intent in general.     

There are good reasons for keeping the ‘considerable time’ language and strong argument for removing.  Because the new subcommittee on communications is likely to have some input on the matter, either individually or collectively at this or subsequent meetings, we might review the members of this panel as relates to their tendencies regarding monetary policy communication and guidance. 

The subcommittee is comprised of two members from the Board of Governors (Stanley Fischer and Jerome Powell) and two District Bank Presidents (Loretta Mester (Cleveland) and John Williams (San Francisco)).  Among the four, only Williams does not currently vote on policy matters.  Having succeeded Yellen at the Federal Reserve Bank of San Francisco, Williams is seen as supportive of her views on the importance of communication as a policy tool. 

In February at the Money Marketeers of NY University[iii] Williams spoke favorably of a return to qualitative guidance, offering; “…our forward guidance should be aimed at providing the public with a good understanding of the key drivers of our policy decisions.”  At the March FOMC Meeting shortly after that speech, the Fed dropped the quantitative ‘threshold guidance’ for date-referenced ‘considerable time’.   

The most senior member of this subcommittee, Vice-Chair Fischer, has indicated a dislike for forward guidance[iv].  Having had experience using forward guidance as Governor of the Bank of Israel he found it ‘restricted the bank’s future actions when circumstances changed.’  He has offered further; “You can’t expect the Fed to spell out what it’s going to do,” “Why? Because it doesn’t know.”  and “We don’t know what we’ll be doing a year from now. It’s a mistake to try and get too precise.”

Fischer is in a very good position to retard or help to reverse the trend toward ever-increasing levels of guidance.  Fischer’s arrival as Vice-Chair of the Board of Governors, in advance of a shift toward lesser amounts of accommodation may be quite timely.  He can present from a position of experience a convincing view of the dangers of excessive guidance.  As needed levels of monetary policy support diminish on the achievement of stated policy goals, the Fed may have by then learned to communicate without outlining too concisely the outlook for longer-timeframe policy intent. 

 The Federal Reserve Bank of Cleveland’s new President, Loretta Mester recently called for forward guidance change[v]; "I believe it is again time for the Committee to reformulate its forward guidance," adding "…striving for clearer communication will yield benefits, especially as we undertake normalization", a process she feels is complicated by the size and duration of SOMA holdings.  Considered to have hawkish tendencies, Mester will likely side with Fischer in the interest of using less forward guidance overall in policy communication. 

Finally, Fed Governor Jerome Powell rounds out the new subcommittee on communications.  Powell, days before taking oath of office in June to begin a fresh 14-year term on the Fed Board, spoke out in favor of forward guidance[vi]; ‘In my view, forward rate guidance has helped reduce medium and longer-term interest rates, and by doing so has provided meaningful support for the economy. First, by increasing public understanding and market confidence in the path of rates, guidance has helped reduce term premiums. Second, by communicating that rates would remain lower for longer than market participants might otherwise have expected, guidance has lowered medium- and longer-term rates through the expectations channel. Finally, even when guidance has initially been well aligned with market expectations, it has reduced the likelihood that rate expectations will subsequently shift upward in ways that the Committee does not intend. Event studies as well as market-implied quotes and surveys corroborate the view that guidance has reduced medium- and longer-term interest rates and has held down volatility as well. To be sure, there have also been times when forward guidance and market expectations have diverged, with resulting spikes in volatility. Such situations may be difficult to avoid, given the use of new, unconventional policy tools, although we always try to communicate policy as clearly as possible. ‘  

A very crude interpretation of the above would place Messrs Powell and Williams together leaning toward continued use of forward guidance and for Mr. Fischer and Ms. Mester calling for less.  Although the time is not now upon us, Vice-Chair Fischer is expected eventually to win out, prompting the Fed to scale back on its forward guidance as it moves more deeply into the process of accommodation removal.  Should he fail however in that effort, the repercussions may be quite similar to the last time (mid-’04 to mid-’06) the Fed used too much forward guidance (‘measured pace’) while ‘intending’ to be less accommodating (see ‘The Dark Side of Fed Transparency’[vii]).

Process of Normalization Doesn’t Now Include Dropping ‘Considerable Time’

The best argument for dropping the use of date-referenced ‘considerable time’ language in the September FOMC meeting Statement is that ; There appears to be less need ‘to support continued progress toward maximum employment and price stability, as the Committee today need not reaffirm its view that a highly accommodative stance of monetary policy remains appropriate.’  Further, ‘The Committee having assessed the progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation has determined that continued support, need not include the maintenance of the current 0 to 1/4 percent target range for the federal funds rate for a considerable time.’ 

To be frank, the market is just not ready for a message that is ‘interpreted’ as indicating a relatively soon lift-off date.  Instead, the Fed will continue to use the term ‘considerable time’ until a very strong majority has denounced its value in describing appropriate monetary policy guidance - most likely at December’s FOMC meeting.  Adherence to this December meeting schedule will allow the Fed to remove the ‘considerable time’ language with the result being a collective, thankful sigh by economic agents instead of a strong and unwanted upward adjustment in interest rates and a reduction in levels of supportive risk assumption if the Fed were to spook market participants by dropping the language too early.

It is not necessarily appropriate that economic agents place such importance to the term ‘considerable time’.  Clearly the Fed has outlined extensively the conditions that shall be expected to prevail when it believes excess accommodation will be less needed.  While progress toward those goals has been keen, repeated overestimation of forward economic prospects has persuaded many Fed officials to allow slightly overstimulative policies to remain in place beyond their time rather than dismissed prematurely. 

Recognizing that benefits in keeping current Statement language outweigh its removal, the Committee will, with some grumbling on both sides of the aisle, elect to maintain the date-reference ‘considerable time’ reference. 

Policy Prescription Further Afield

As earlier indicated, the Minutes of the July FOMC Meeting gave considerable attention to the process of ‘Monetary Policy Normalization’ prompting me to offer an analysis of the Minutes[viii].  Below are some points that deserve additional attention (italics, bold and underline are my additions):
  • ‘Meeting participants continued their discussion of issues associated with the eventual normalization of the stance and conduct of monetary policy, consistent with the Committee's intention to provide additional information to the public later this year, well before most participants anticipate the first steps in reducing policy accommodation to become appropriate.’  The Fed will bring forth additional information on how they intend to normalize the stance and conduct of monetary policy.  They will not provide that information in the September FOMC meeting Statement nor will they give a specific outline of the process in the Minutes for the September meeting.  Instead, they will provide that guidance ‘later this year’, probably in October, but possibly not until the December Meeting.  Otherwise they would have said ‘soon’ to indicate September.
  • ‘The staff detailed a possible approach for implementing and communicating monetary policy once the Committee begins to tighten the stance of policy.’   The Fed has ‘the’ exit strategy fairly well hammered out as indicated by the staff providing only ‘a’ single possible approach.  There were two meeting participants seemingly not fully onboard, but they will be swept along with a consensus vote.  The Fed is capable of presenting this exit strategy today, but will wait for a time when they can provide that information together with some additional guidance which is intended to be supportive, such as an intention to refrain from outright portfolio sales until at least 2018. 
  • ‘In general, they agreed that the size of the balance sheet should be reduced gradually and predictably.’  The Fed will at some point make available a ‘policy path’ description of the reduction in the reinvestment of principal and interest, thus providing some level of communication support despite the action of discontinued reinvestment as otherwise being less accommodative.  This approach is consistent with that used for the ‘policy path’ reduction in securities purchases; otherwise know as ‘tapering’.     

Connecting the Dots

The Fed has consistently scaled back its estimate for ‘longer run’ GDP growth and recently scaled back its estimate for the appropriate longer run or equilibrium target policy rate.  It is difficult to call the timing to the end of this trend.  Many feel there is room for further reduction to both in the updated release of the Summary of Economic Projections (SEP) provided at this meeting.  Currently the longer run real GDP forecast is 2.1-2.3% as a central tendency.  This central tendency forecast was as high as 2.3-2.5% as recently as June of last year.  Similarly, the longer run SEP forecast for targeted fed funds rate was 4% since 2012 and reduced to 3.75% at the June, 2014 meeting. 
References for longer run real GDP and targeted fed funds rates are not expected to come lower at this meeting.  Additionally, there is room for the SEP expectation for year-end policy rates for 2015 and 2016 to move slightly higher from 1.13% and 2.5% respectively in June.    The initial SEP forecast for year-end 2017 target fed funds rate may be very near or even at the longer run 3.75% latest posting.     

[i] Martin McGuire; The Fed and Interest Rates; FOMC Report July 29-30, 2014; http://www.thefedandinterestrates.blogspot.com/2014_07_01_archive.html
[ii] Vice Chair Janet L. Yellen; At the Society of American Business Editors and Writers 50th Anniversary Conference, Washington, D.C. - April 4, 2013; ‘Communication in Monetary Policy’ http://www.federalreserve.gov/newsevents/speech/yellen20130404a.htm

[iii] Federal Reserve Bank of San Francisco; February 19, 2014; ‘Fed’s Williams Talks Qualitative Guidance’ http://www.frbsf.org/our-district/press/news-releases/2014/economic-conditions-monetary-policy-transition-speech/

[iv] The Wall Street Journal; September 23, 2013; ‘The Key to Forward Guidance? Don’t Give It, Fischer Says’; http://blogs.wsj.com/economics/2013/09/23/the-key-to-forward-guidance-dont-give-it-fischer-says/

[v] Reuters; September 4, 2014; ‘Cleveland Fed’s new chief calls for forward guidance change’; http://www.reuters.com/article/2014/09/04/us-usa-fed-mester-idUSKBN0GZ25F20140904

[vi] Governor Jerome H. Powell; At the 2014 Spring Membership Meeting, Institute for International Finance, London, United Kingdom - June 6, 2014; ‘A Conversation on Central Banking Issues’; http://www.federalreserve.gov/newsevents/speech/powell20140606a.htm

[vii] Martin McGuire; The Fed and Interest Rates; ‘The Dark Side of Fed Transparency’ – FOMC Report October 25, 2006; http://www.thefedandinterestrates.blogspot.com/2006/10/dark-side-of-fed-transparency.html
[viii] Martin McGuire; The Fed and Interest Rates; ‘Analysis of Minutes of the Federal Open Market Committee;  July 29-30, 2014; http://www.thefedandinterestrates.blogspot.com/2014/08/analysis-of-minutes-of-federal-open.html