Wednesday, July 19, 2017

FOMC Report July 25-26, 2017; July FOMC Statement to Leave Door Open for September Hike

Inflation never seems to come at a time or in a form preferred.  There is always too much of the wrong kind or never enough of the good kind.  And so it is today that while household budgeters argue that it is ever harder to make ends meet, the Federal Reserve holds that a shortfall from achieving its targeted 2% goal could endanger longer run economic prospects. 

Of course, the zeroing in on policy goals of maximum employment and steady 2% inflation, directs the FOMC policy making decisions.  While there remains some argument that the slack in employment has not been fully cleared, it is generally understood that the employment situation is somewhat near the Fed’s full employment goal.  However, greater concern is voiced by many about the slow and to some a retreat rather than a temporary slowing in the advance of inflation toward achieving its 2% objective. 

Slow productivity and an aging population may be contributing to the breakdown of the Taylor Rule and are culprits thwarting Fed from achieving their inflation goal.  It is possible also that the targeted 2% is simply too high a goal given structural changes and that the Fed should instead be satisfied with an inflation growth of 1.5% or so.  Others however would argue that because of the failure to achieve stated inflation goals of 2% for so long, the Fed should instead target a higher inflation goal in order to ‘catch up’ and show resolve. (see Woodford)[1]   

Public confidence brought on by the recognition and anticipation of monetary policy developments and policy implementation has led to economic growth that has been greater than would have otherwise been the case had monetary policy progress been less identifiable.  The understanding of monetary policy path has been a rather friendly element to the benefit of economic and financial market conditions of late.  It is suggested as a cautionary note that changes to this dynamic could cause an outsized negative impact on economic and financial market conditions due to the potential for a change in the risk taking attitudes of economic agents. 

 The global economy is not so robust today that it can withstand a significant reduction in the level of Central Bank ‘visibility’ (a step beyond ‘transparency’, visibility is the ‘usefulness’ or value associated with policy certainty, expressed in beneficial economic growth through encouraged risk taking – see also McGuire - Monetary Policy Theory)[2].  Additionally, the ECB has given some indication recently of considering its own scaling back in accommodation provided.  Finally, gains in asset classes have not to date been beyond reason and have not as yet suggested excessive malinvestment[3].    

What is clear is that the Fed should continue to do all that it can to promote policy ‘visibility’.  While there has been some disagreement about the transitory nature of the inflation shortfall, what has been understood is that the pace of the policy path has been a rise in the policy rate of 25 basis points every quarter since December 2016.  It may not be appreciated well enough how conditional economic growth is on the continuation of that policy path and the benefit from the visibility that path provides. 

I would argue that maintaining the current policy path is particularly important and that in the absence of a highly warranted and long lasting policy shift, the Fed could do great harm by failing to continue removing policy accommodation on a steady course at the September FOMC meeting.

In short, the benefit from maintaining a known policy path (raising the fed funds policy rate to the 1.25-1.5% range in September) in terms of enhanced economic growth by way of improved risk appetite could far exceed any potential gain associated with an otherwise lower fed funds rate.  Instead of pausing in the application of policy accommodation removal, the Fed should continue to move in a steady manner, bringing additional stability to economic growth through added visibility associated with a know policy path. 

Some have argued that because of the shortfall in inflation or too because of the slightly less robust growth data of late, the Fed should begin its balance sheet reduction plan, thus replacing it for a policy rate move.  Kind of a ‘tightening light’; Some contended that because the balance sheet reduction plans, especially early on, are expected to be not nearly as strong an accommodation reduction as would be an additional policy rate increase, the Fed should substitute reduction of the balance sheet for rate hikes until a clearer picture of greater economic prosperity and higher inflation returns.  

Others however argue that central bank balance sheet reduction can have a devastating effect on commercial and investment bank portfolios and could induce much higher sovereign yields than is widely expected.  A substitution of a Fed balance sheet reduction plan in the place of a policy rate response could be a two edged sword attacking economic growth by removing policy ‘visibility’ while at the same time ushering in higher bond yields through the reaction of commercial and investment banks as they make their own balance sheet adjustments.

It is too soon for the Fed to begin a balance sheet reduction.  Remember please the time required to adjust to the notion of the Fed tapering its balance sheet additions back in 2013.   It was clearly a policy mistake in mid-2013 for then-Fed Chair Bernanke to blurt out the prospect for scaling back security purchase plans on the open ended policy prescription without providing additional policy path guidance.  Market participants, once beyond the initial shock (nearly 100 basis points higher US Treasury ten year yields), waited impatiently for further definitive word on the subject.  Not until the December FOMC meeting were those details revealed.  By then, economic agents had been begging for the tapering announcement.   That is what is needed again here – economic agents are not yet ‘hungry enough’ for balance sheet reduction. 

By delaying the announcement of the start of the reinvestment slowdown until December, the Fed will find that not only were economic agents anticipating its arrival, they were also anxious in moving on with the transition.  Announced after some delay, economic agents will again react more positively to the news.  We should not expect as strong a positive response as was seen following the December 2103 FOMC meeting announcement of tapering where ten year Treasury yields fell nearly 50 basis points lower in less than three months.  However, delaying the initiation of the balance sheet reduction until market participants are clamoring to move on would likely soften the impact of that event.   

The Fed would do well to wait longer to announce the timing and initiation of the balance sheet reduction.  By having economic agents continue to raise their expectations for its roll out, the impact from that eventuality will become increasingly less significant.  Because the scale back process itself is slow and predictable there is an element of policy path awareness that, like the tapering in 2014, can provide some beneficial ‘visibility’. 

Much of this report has been about what the Fed should do at the September FOMC meeting.  The July meeting is important only in how it readies the stage for the September meeting.  And while the Fed has advised for some time, and rightly so, that every meeting is ‘live’, there is only downside to providing more information than economic agents require at this meeting.

That means that the Fed should be expected to indicate that progress on inflation is still ongoing despite what is considered low levels in this transitory period.  Additionally, the Fed will again advise that conditions are in place to warrant greater spending levels by households, that business investment has been strong and global economic conditions have improved.  All of this will allow economic agents to digest forthcoming data, price in a greater chance for a September policy rate move and a push out of balance sheet reduction until later this year.     



[1] Michael Woodford: ‘Methods of Policy Accommodation at the Interest-Rate Lower Bound’;

[2]   FOMC Report April 26-27, 2016; Financial Market Calm With Unimpressive Growth’

[3] Malinvestment: In Austrian business cycle theory, malinvestments are badly allocated business investments, due to artificially low cost of credit and an unsustainable increase in money supply. Central banks are often blamed for causing malinvestments, such as the dot-com bubble, and the United States housing bubble.

Tuesday, June 13, 2017

FOMC Report June 13-14, 2017; Less Orderly Though Possibly Still Quarterly (…rate hikes)

The Federal Reserve is expected to raise the fed funds policy rate by 25 basis points and leave its guidance largely unchanged in the statement following their meeting this week.  That message has consistently expressed an interest in returning the policy rate to a more ‘normal’ level or more generally to reduce the overall level of monetary policy accommodation.  Despite less favorable general economic growth conditions during the first quarter, the Fed has conditioned market participants for an additional modest reduction in the level of accommodation provided. 

Some Fed officials are likely to voice concerns ( Minneapolis Fed President Kaskhkari a possible dissent) about continuing the removal of policy accommodation at a time when there is uncertainty about the potential for a lasting nature of the economic weakness and lower inflation prints seen earlier this year.  Clearly however, there has been a pattern of weaker economic growth in the first quarter followed by stronger growth toward the last three quarters (see ‘FOMC Report May 2-3, 2017; Still Quarterly and Orderly’).  This historic pattern alone is not reason enough to expect the Fed to lock into a policy path of quarterly 25 basis point rate hikes.  However, job growth continues to be strong and household incomes and wealth conditions are improving while global economic conditions are in repair.

This leaves room for my earlier forecast of ‘Quarterly and Orderly’ policy rate hikes this year to remain on the table, though less likely.  Economic growth will need to improve in order for the Fed to hike rates by 1% this year and there is little room for more than a modest geopolitical distraction.  Otherwise, the Fed is expected at this meeting to concentrate on where it stands now despite uneven growth and inflation paths rather than on exaggerated emphasis on what developments might be forthcoming. 

While the Summary of Economic Projections (SEP) will be parsed in order to extract a greater meaning than is truly available, we expect the 2017 year-end PCE inflation, GDP and unemployment projections to all be lowered by 0.1%.  We look with interest to see if the longer run unemployment rate expectations are lowered, though we think not at this stage.  Should the Fed leave the longer run unemployment rate forecast at current levels, this could provide some assurances that it is believed much of the slack has already been removed from employment condition.  This would mean too that the impact from strong labor market conditions on financial conditions is likely to overwhelm the recent and largely believed ‘transitory’ weakness in inflation.    

It is difficult to say why wage pressure has not been greater to date and even harder to know at what pace wage pressure may emerge in the face of continued outsized job gains.  A sense of stable wages conditions has been engrained because of weak productivity growth which followed higher levels of unemployment earlier.  While productivity for now remains at low historic levels, the psychology of employees and employers as concerns appropriate wage gains may change more rapidly with any further labor gains.  Productivity gains are not entirely necessary for this development. 

Finally, although there was some talk at the May FOMC meeting of a scale back in the measure of reinvestment of the Fed’s balance sheet beginning as early as this year, I still anticipate the actual run off of the balance sheet will not start until 2018, with an announcement in December.  As such, I do not expect a detailed announcement of this latest ‘tapering’ plan released at this meeting.  Instead, further details excluding the specific timing are likely forthcoming at a meeting between the July and the December meeting.    

Tuesday, May 02, 2017

FOMC Report May 2-3, 2017; Still Quarterly and Orderly

Economic growth in the first quarter was underwhelming as it has been in the first quarter for a number of years (Figure 1).   Stronger economic performance over the last few months might have made the Federal Reserve’s job of communicating its intention of moving forward with the removal of monetary policy accommodation easier.  However, we do not expect the Federal Reserve to be sidetracked in their intention to raise policy rates at a gradual pace.

There is no policy action expected at this FOMC meeting.  Instead, the Fed should be expected to indicate that economic performance is improving, that any slack remaining in the jobs market is being removed and that inflation is projected to reach its 2% target in the medium term.  Otherwise, the statement from this meeting is going to be like the bread served at a buffet dinner, intended to fill you up without providing much substance. 

Going back to 2009, the average first quarter Real GDP growth rate was less than 0.3%, far below the 1.8% overall average during that time span.  Even if we remove the extraordinary -5.4% first quarter 2009 contraction from our series, the first quarter average is still only 1%, less than half the overall period average.  Since 2009, the only quarters showing negative growth have been first quarter results.  At any rate, while the Fed will certainly take into account this year’s weaker first quarter data, they are unlikely to reformulate their policy path projection from what I have termed ‘Quarterly and Orderly’.  

The minutes from the March FOMC meeting gave considerable attention to the balance sheet and discussions about its reduction.  This of course attracted a lot of attention and rightly so.  We believing that Chair Yellen will want to at least have begun the process of removing the reinvestment of maturing securities held before her term ends early in 2018.  Some, including Scott Minerd of Guggenheim on Friday at the Milken Institute Global Conference, suggest the Fed might initiate a policy change therein as soon as September. 

My expectation is that the Fed will wait until December to outline a gradual and defined process of removing reinvestments which will begin in January 2018.  Waiting until December of this year appears more plausible, especially given the, once again, weak first quarter economic performance.  This timing would be consistent with the approach taken at the December 2013[1] FOMC meeting when the Fed announced it would begin to scale back the amount of securities purchases (taper) in a ‘path-dependent’ format that would be concluded by October of 2104.  We were delighted then in predicting the Fed’s course of action (FOMC Report December 17-18, 2013) when few saw similarly. 

A policy rate path that includes quarterly (March, June, September and December) 25 basis point advances in the target range will move Fed Funds to 1.5-1.75% in December, roughly halfway to its stated ‘Longer run’ projection of 3%.   Beginning a balance sheet adjustment when Fed Funds target rate is 1.5-1.75% would be consistent with the Fed’s long stated intention of waiting ‘until normalization of the level of the federal funds rate is well under way’.