Tuesday, September 20, 2016

FOMC Report September 20-21, 2016; Monetary Policy in the Awkward Middle

Executive Summary: 

The Fed is not expected to raise policy rates at this FOMC meeting.  The odds of such a rate hike are at 10% by my estimate and remain this high because of the particularly disjointed message received from Fed officials since their meeting in July.  A stronger case could be made for a policy response at this meeting, but such a unified message was not articulated by Fed officials.   Economic prospects rather than overwhelming evidence from current conditions are not believed sufficient to carry a decision to raise policy rates at this meeting.  Instead, a stronger message in the statement and post meeting press conference will be the concession to the more hawkish Fed contingent.       


Monetary Policy in the Awkward Middle

Federal Reserve monetary policy has returned to the ‘no man’s land’ between easier and firmer monetary policy regimes.  Despite ever increased central bank communications and continued efforts in increasing transparency, the Fed appears increasingly less able to impose an imprint even on policy actions, much less economic activity.  Fed talk of firmer policy initiatives down the road gets pushed to the shoulder as each initiating point comes more clearly into view. 

At this stage, the initial December 2015 rate hike is so far in the rearview mirror that to suggest that a next rate response is connected would be a stretch.  The notion of ‘gradually’ returning to a more normal policy stance while being governed by a ‘data dependent’ yardstick has offered communication challenges from the start.  While the former implies some regularity, the latter is both suggestive of a rule-based approach and at the same time left to interpretive influences.  The Fed has tried to straddle the line between providing guidance and allowing expectations for their policy initiative to be interpreted by reading into the flow of economic and financial data.  This would of course be made easier if everyone was in agreement as to what the Fed’s reaction function is or should be.   Interpreting monetary policy from economic and financial market data is made all the more difficult because is no universally recognized Fed reaction function.

For now it is important to recognize that policy mistakes made in the middle ground between an easy and a restrictive policy regime carry greater weight.  While both sides of the policy regime coin offer the market stabilizing influence from a known, implied, envisioned or imagined ‘policy path’, that stability of policy path is absent as the coin stands on its side between heads and tails (accommodative and restrictive). 

When the Fed is widely understood to be carrying out a restrictive monetary policy initiative, some adjustment should be expected as data comes to light that does not jibe with market expectations for already priced pace for the removal of accommodation.  Similar conditions exist for easier monetary policy regimes.  However, market adjustments made when neither policy regime is in place tend to be of greater magnitude because economic agents have less confidence in their ability to interpret the monetary policy response to changes in current conditions.  The lack of a monetary ‘policy path’ leaves absent the potential for modest scaling to or from those prior expectations.  Instead, in the monetary policy middle ground, each modest outlier from expected data requires a reformulation of policy expectations and thus greater market volatility.     

As such, when the Fed finds itself between policy regimes and without a more firmly recognized policy path, it is all the more likely to delay a policy response that is not more widely expected by economic agents.  This is true at an extreme where policy rates had earlier been driven higher and have peeked before coming lower, but is even more important to understand this when policy rates rest nearer to the zero bound. 

We should therefore not expect the Fed to firm policy rates at this September FOMC meeting.  The risk for surprising economic agents does not appear likely to be offset by any sizeable benefit from raising rates.  Therefore, it is more likely that more hawkish Fed officials will position for is a stronger statement and more upbeat assessment in the post meeting press conference.


Summary of Economic Projections

The Summary of Economic Projections (SEP), is expected to show a majority of Fed officials are looking for one ‘additional’ rate hike this year.  Even though there has been a strong voice within for the Fed to firm policy rates, the continued discussion of low and falling equilibrium level of interest rates (r*) suggests that the path for policy rates implied by the ‘dot plot’ will be reduced through 2017-2018.  In line with gradual reductions in forward expectations in the past, it is likely that the median estimates for 2017-2018 and even longer run will be reduced by roughly 25 bps.  It is not as clear that the longer run fed funds rate will be lowered at this meeting.  This may be a concession that the Fed doves can give in order to placate the officials with more hawkish desires.  GDP growth for 2016 will likely be scaled back further (1.7-1.8% from 2% June) because of a slower than expected Q3.  The balance of the SEP is not expected to see great change.    


Tuesday, July 26, 2016

FOMC Report July 26-27, 2016; July Meeting 'Live', But Certainly Not Lively

Executive Summary:

The FOMC will refrain from policy rate action at this July 2016 meeting.  The statement following the meeting will highlight improving economic conditions, but that language will not be forceful enough to encourage economic agents to price as much as a 50% chance for a September rate hike.  To the extent language on improving domestic economic conditions might by itself sway market participants toward pricing in too great a chance for a September policy response, reference to global conditions will be used to offset such impulses. 

Financial Market Stability Not Steady Enough:

Global bond yields swooned following a near universal call by central bankers in particular and government officials more generally that uncertainty was at a higher plane.  By inference therefore, the ability for governing bodies to make appropriate, forward looking decisions was assumed to have been curtailed.  One might envision such heretofore decision makers sitting on their hands in wide-eyed amazement, hopeful some answers come to them that don’t also carry any needed additional qualification. 

We have of course always lived in uncertain times.  The adjustments we make are designed to put us back to the path we expect aligns us with our longer run goals.  And though the balls currently in air may differ in color and quantity than the juggler is accustomed, it is still the same art he professes to practice.  Juggle on Yellen.  Juggle on Draghi.  Juggle on Carney. 

In my April FOMC Report, financial market stability was noted as of paramount importance; allowing ‘the Fed some level of confidence that they might provide economic agents some policy path for the return to more normal policy rates.’  Further, financial market stability would be self-supportive of greater levels of risk tolerance by economic agents as baseline economic growth improved with spending and investment.  Finally, some support to economic growth would be expected to accompany a greater understanding of monetary policy intent even if that objective was toward modestly higher policy rates. 

Financial market stability however, has not been steady enough for the Fed to move forward with policy normalization at the July FOMC meeting.  Instead, there was a violent jolt to an otherwise quieting market when the U.K. ‘Leave’ vote was registered.  Market participants initially reacted to the news as if a ‘black swan’ had just been spotted.  Adjustments since that immediate response have proven much more subtle and supportive of additional risk tolerance.

Financial market stability, to the extent seen over the last month, has been accompanied by more constructive economic data.  Since the Fed met in June, nearly every barometer of domestic economic activity has shown modest positive surprise.  Were it not for the interruption to financial market stability brought about by the unexpected UK vote, the Fed might have been ready to raise rates in July.  Instead, following the UK vote and in part too because of the surprisingly soft May employment data, economic agents pushed the pricing of any further Fed accommodation removal well into next year. 

As it is now, with the aforementioned tempered financial conditions and supportive domestic economic data, the door may be opened at the July FOMC meeting for a Fed policy move in September.  Continued economic gains and financial market calm will be required however before a September rate response can be put squarely on the table. 

Fed View of Likely Path:

We may gain some sense of how interested the center of the committee is in raising rates as soon as possible by what they choose to emphasize in the statement.  The most recent labor report as well as retail sales were a measure above what was seen prior to the June FOMC meeting.  Inflation too has moved up modestly.  The Fed could choose to emphasize domestic growth, inflation or global conditions.  If the Fed wants to ready the market for a policy response initiated at the earliest convenience, without promising one, they are more likely to emphasize the recovering economic data rather than improvement in inflation.  By doing so, they would be pointing toward a longer standing condition.  While the right domestic ingredients for modestly increasing inflation exist, evidence of those conditions being expressed is not long lasting enough to be considered a trend. 

The Jackson Hole Option:

Last year, Fed Chair Yellen may have thought that the annual Jackson Hole Symposium was becoming too important a staging area for new monetary policy direction and thus made herself unavailable for that confab, which as it turned out came only months before the Fed raised the policy rate for the first time in nearly a decade.  This time around, Chair Yellen is a scheduled speaker, giving her the opportunity to provide some further guidance on policy intent. 

At the risk of elevating the status of the Jackson Hole Symposium, but with some interest in raising rates by the end of the year, the FOMC may wish to downplay rate hike prospects in the July FOMC statement.  That would reduce the chances for the market pricing too strong a reaction while leaving the Jackson Hole confab available as tool for further guidance should subsequent economic data allow. 


While financial market stability has not been long lasting enough to allow a rate response at this stage, referencing an improvement in economic data rather than inflation would leave the door open for a later-year rate hike that includes September as a possibility.  The FOMC does not need to be too forceful in guiding economic agents toward growing prospects for a rate hike because it can use the Jackson Hole Symposium in late-August to, if necessary, provide updated policy intent.   

Wednesday, June 15, 2016

FOMC Report June 14-15, 2016; Gradual is as Gradual Does

The gradual pace for ‘normalizing’ monetary policy Fed officials have since December indicated as appropriate is only one meeting away from becoming a dated concept and unsuitable.  As relates to monetary policy, gradualism implies at least some movement.  For most, a pace recognized as gradual would include some policy movement at a minimum roughly semi-annually.  Therefore, a next-move in policy rates further afield than July would not really be suitably termed gradual. 

A policy move later than July, if connected at all to the December initial policy rate hike suggests the pace of normalization be more appropriately termed ‘sluggish’ or ‘unhurried’, if not ‘ad hoc’.  The time lapse between policy rate moves at this juncture is no small matter and is not easily dismissed. 

It has been a long time since economic agents were afforded any meaningful guidance from the Fed which might reduce uncertainty surrounding monetary policy.  Not since the Fed finished tapering securities purchases have economic agents had helpful visibility[1] (McGuire, 2016) from Fed transparency.  Mindful of their inability to provide significant visibility, the Fed has said that the unfolding of economic data (data-dependent) would guide Fed officials in determining the appropriate timing of policy normalization moves.  Now however, the Fed is indicating the very nature of the economic data gathered brings into question their ability to determine the correct policy response.      

Fed Chair Yellen appeared to make every effort possible in her June 6th speech ‘Current Conditions and the Outlook for the U.S. Economy’ delivered at The World Affairs Council of Philadelphia to convey a message of doubt.  She noted; ‘In particular, an important theme of my remarks today will be the inevitable uncertainty surrounding the outlook for the economy.’  Indeed, she offered just that.  Chair Yellen did describe current conditions, but she did so in relation to a discussion on uncertainty.  She used the term uncertain no less than 15 times in here remarks.   So conveyed was the notion that there can be no monetary policy guidance at this stage that it is surprising that financial markets did not react more violently.

It is widely understood that a good accounting for the effectiveness of Fed transparency is gauged by the amount of market volatility immediately following the post-FOMC meeting communication.  If the Fed is able to provide a good sense for the conduct of monetary policy and thus likely outcome of the FOMC deliberations, asset prices should be fairly adjusted to a post-meeting message.  It is argued such transparency leaves little room for asset price volatility thereafter.  Fed Chair Yellen made clear in her recent speech that even if there was a willingness to provide such guidance, it was simply beyond the capacity of the Fed to offer any direction in monetary policy prospects given current conditions.       

Because of the Feds difficulties parsing current economic conditions, it is realistic to expect some change in the dynamics between the meeting statement and market response from this and possibly future FOMC meeting deliberations.  Under circumstances less desperately described as Chair Yellen noted in her June 6th speech, market participants could be rather confident that post-meting volatility would be checked or tempered by the likeness of the statement message to the pre-meeting conditioning.  At the June meeting however, meeting participants (as well as economic agents at large) may have quite dissimilar views, sculpted in large part by more recent economic data which could prompt a message and policy direction quite alien from what the market has currently priced.  

In any event, it is quite conceivable that economic agents are prone to respond more aggressively to any post-meeting message than at any time in recent past.  Chair Yellen indicated the highly unpredictable unfolding of economic conditions with implications for similar uncertainty as regards monetary policy.  Under such circumstances, the reaction to post-FOMC meeting communication could be considerably more volatile than what has been the longer run norm. 

There are two primary reasons for a greater chance for market volatility following the FOMC meeting.  First and most obviously, the Fed may leave more unsettled the chance for a policy response in July.  Secondly, it may more largely distance itself from the prospects of a July rate response.  In the first instance, reduced visibility would lead to greater volatility.  More importantly perhaps, in the latter, the creditability of the Fed’s long held commitment to a gradual pace for monetary policy ‘normalization’ is threatened.  As such, the Fed has ample reason to indicate at a minimum that the July meeting is still ‘live’, if not a likelihood for a policy response.   

Had the initiation of ‘normalization’ been delayed, possibly from December to March, the notion of gradual might still apply.  However, should the Fed be required to postpone the next rate response beyond July, the very idea that policy normalization is progressing would be at stake.  Even as the Fed has made perfectly clear that data dependence is at the forefront of policy deliberations, gradualism supposes that the unfolding of that economic data will allow for policy movement.  Otherwise, it simply would not be fit for the Fed to qualify its course of action as gradual. 

It is the nature of that data unfolding which is expected to provide reason for a gradual pace for policy normalization.  Economic agents might rightly differ as to their understanding of the limits to the delay between policy moves which could still be considered as gradual.  However, if policy response is not seen in a timely enough manner to qualify largely as gradual, then it must be assumed that there is really no ‘path’ (gradual or otherwise) for policy rates and the Fed is operating in ad hoc fashion.

The implications for financial market stability are not small when considering operation under ‘gradual’ verses an ‘ad hoc’ frame of reference.  Gradual implies a policy path, which though not strongly defined allows some capacity for predictability.  This policy path aspect or implication of gradualism in terms of monetary policy application invites stability as it lends visibility through Fed transparency.  Monetary policy operated under an ad hoc framework simply cannot provide any such policy path framework and would therefore more generally lend itself to promoting rather than reducing volatility.    

Further, a gradual pace for monetary policy action implies some ability to model such a framework.  That is gradualism implies some regularity or degree of predictability which can be used in model building.  Whether that predictability is fitted into multi-variable econometric models or simply assimilated into the projections of average consumers, a change to a less predictable state can have dramatic repercussions.  They will likely reduce both the value of the output from econometric models and would of course reduce the willingness of consumers to spend and businesses to invest. 

Models built upon projections for monetary policy are often more robust when they are kept uncomplicated.  Right now, many models using policy projections presume a slightly less than gradual pace for policy firming.  This is evidenced in the pricing of interest rate derivatives (futures and options) that assume rate firming of less than 50 bps per year over the intermediate term of 1.5 years.  These models are stretched to their limit in their ability to provide meaningful output.  It is difficult for these models to recognize as a continuous policy regime, policy action that is separated by more than six months.  Using recognized economic projection techniques, there is little room beyond current conditions to provide meaningful model output from even less timely policy responses.  They simply become too distant from one another to be considered consistent with one policy regime and instead become ad hoc or distinct. 

While there has been more than a few who suggested the December rate hike would be the only such removal of accommodation (‘one and done’), the Fed has clearly not given up on the notion that further accommodation removal will be appropriate.  In order for financial conditions to remain calm following the June FOMC meeting statement, the Fed will need to give some assurances that the data has been sufficient to warrant strong consideration for July as a next-response meeting.  Otherwise, the notion of gradual policy unfolding is lost and Fed guidance, largely absent for nearly two years is completely missing.  Without stronger economic performance, a rudderless monetary policy might be too difficult a burden for economic agents to bear and a wide scale reduction in risk appetite could ensue. 

We are therefore very cautious on the approach of the June FOMC meeting and while we suspect the Fed will provide assurances that they are still operating similarly and that July is a ‘live’ meeting, unless they can make such an argument believable, a strong ‘risk-off’ preference could prevail. 

[1] [i][i] ‘Visibility’ (The ability to see or be seen; the quality or state of being known to the public) as regards monetary policy is very much different from ‘transparency’ (Transparent-able to be seen through; honest and open: not secretive) in that visibility is something that can be seen whereas transparency only speaks of the lens by which reality is viewed.  Think of a windshield as providing transparency for a driver.  A clean windshield allows the driver to see clearly the road ahead.  A muddied or rain splattered windshield would limit the transparency of the window regardless of the situation ahead.  Visibility is the extent the drivers view is unobstructed beyond the windshield.  If he is on a long, straight and open road, his visibility is high.  If he is on a crowded and highly curved mountainous road, his visibility is limited. 
The Fed can more easily keep the windshield clean (muddied) as it prefers in providing information (keeping information secret) to the public than it can produce ‘visibility’.  It offers visibility when it provides believable assurances as to when and how it will adjust its monetary policy.  Currently, the Fed does not have a level of confidence in economic and financial market projections to provide much visibility outside of indicating that it does not intend to end reinvestment of interest and principal for its securities holding until policy rate normalization is well underway. 

Can you imagine any ‘policy paths’ the Fed might create that would provide additional ‘visibility’ that either do not currently exist or have been overlooked as a source for increased financial market stability?  Did you realize that the reduction of latest purchase program in incremental format was an engineered ‘visibility’-add.  Intended or not, this addition of visibility provided greater understanding to policy intent which attracted higher levels of risk assumption than would have been the case in its absence.  Note that when then-Fed Chair Ben Bernanke had in mid-2013 discussed removing or reducing the purchase program without providing a ‘policy path’ for that outcome, the market responded violently to a loss of ‘visibility’ in the purchase program that existed.  It was not until the ‘policy path’ for purchase tapering was unveiled that economic agents again had a renewed sense of policy awareness.  This of course contributed to greater economic growth than available in its absence.