Tuesday, December 12, 2017

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

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

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

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

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

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

Policy and SEP Changes at this Meeting

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

Implication for Current Policy Conditions

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

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

Tuesday, October 31, 2017

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

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

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

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

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

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

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

Tuesday, September 19, 2017

FOMC Report September 19-20; If Unsure, Announce Balance Sheet Reduction

After three consecutive quarterly policy rate hikes, the Fed is likely to allow the fed funds policy path a pace change as it awaits more definitive indication that inflation is proceeding toward its two percent target.  If volatility is to be a guide, there appears some room for path variance from the strict quarterly removal of policy accommodation.  Actual and implied volatility measures remain at historically low levels as the September FOMC meeting approaches.

Low levels of volatility are generally welcomed as they speak of some level of confidence afforded current and the immediate future state of affairs.  Clarity of Fed intentions is a strong driving force for market implied volatility and the term premium on bonds. 

For over 12 years I have discussed how economic agents will adjust their levels of risk taking on the basis of the ‘visibility’ of the Fed’s policy path.  Visibility is like Fed transparency on steroids as it leads to a much clearer vision of future policy rates, whereas transparency is simply an open book.  In 2005, when I first started writing about this less understood condition, my intention was to express concern that the ‘restrictive’ policy path the Fed was trying to execute was a historical blunder.  The visibility provided by a telegraphed “measured pace” policy initiative encouraged rather than discouraged risk taking.  At that time, economic growth was well above potential and a more serious effort was needed to check animal spirits.   

Since the onslaught of the financial crisis, many have acquired a greater respect for the nature of Fed guidance.  Seen even as a policy tool now, Fed guidance is used when policy rates are too near the zero bound for lowering and as a substitute, assurances are made as to the duration the Fed will hold the policy rate at a low level.

It is the path understanding more than it is the particular rate which gives the benefit to animal spirits.  As the Fed moves away from regular policy rate hikes, as is now likely the case without a rate hike at this September FOMC meeting, there is a risk that insufficient policy awareness may prove detrimental to a willingness otherwise to engage in productive enterprise.  Right now, the Fed seems to be given a pass on September.   

Market pricing of Fed Funds and Eurodollar futures suggests roughly a 50% chance for a December rate response.  However, unless the Fed does raise the policy rate in December, there may be a strong reaction to the break from the earlier, three ‘dot’ declared, ‘predetermined’ policy path.  The Fed returning to a more ‘data dependent’ guideline for policy rate determination rather than the current more scripted path, could cause an upheaval in the form of higher volatility as economic agents become less convinced they understand the likely path for policy rates.

Consider the charts below that demonstrate the tendency for measures of volatility to respond to a certainty surrounding the visibility of the fed funds policy rate path.  The Merrill Lynch Bond Volatility Index (‘MOVE’) and VIX moved lower as economic agents came to understand the Fed’s policy path back in 2005.  Those volatility measures then began to increase when the Fed’s policy path became less known.  


Notice how the indexes fell hard as the Fed moved into its ‘measured pace’ directive and how that ended when the Fed could no longer proved wanted visibility at the onset of the financial crisis.  See also the recent fall in the indexes as the Fed began to show consistency in policy rate path.  


I have used a 30 day moving average to smooth the index data.  I have also included a graph of the ‘term premium’ to help demonstrate that here too, the tendency is for lower term premium in known Fed policy periods and higher term premium accompanies less certain policy rate times. 

Finally, the Fed is widely expected to provide a starting date for the reduction in its balance sheet of Treasury and mortgage securities.  Because this program has been well advertised with exacting details and because initially only a very small bite will be taken out of the portfolio, the announcement of a starting date is not expected to create any meaningful Treasury price movement.  With the recent hurricane activity causing noise to economic statistics, the Fed may be additionally interested in beginning a balance sheet reduction in the near term, lest they are data hampered from adjusting policy rates through year end. 

While, the defined path of the balance sheet removal is a form of policy path guidance that all else equal does provide visibility and by that nature promote positive economic activity, the program does not have as strong an influence on the nature of animal spirits as does the understanding of the fed funds policy path.  As such, we are quite concerned that the absence of a rate hike by December will result in significantly higher realized volatility in the intermediate term which would increased the prospects for a curtailment in the capital investment and household spending.