Nearly Three Years of Policy Visibility
The Fed has added to its stores of creditability by maintaining its policy rate at a long-promised artificially low level through midyear-2015. However, it will be paying back from those supplies if it should remain sidelined much longer while employment and inflation continue to repair.
At an FOMC meeting in September 2012, the Fed made a last adjustment to its dated-based policy guidance, saying; ‘exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.’ While that last date-based policy guidance lasted only until December of that year before the Fed adopted ‘threshold’-based guidance, the Fed advised at that time; ‘The Committee views these thresholds as consistent with its earlier date-based guidance.’ Any change to policy guidance since has included a reference that the change does not alter the intent of the prior guidance message. In a way then the dated guidance of ‘at least through mid-2015’ still stands.
Since the September 2012 FOMC meeting and before, expectations for above trend growth have been followed by consistent and cumulative declines in the potential output expectations. Back in late 2012, the Fed thought the longer run growth potential for real GDP was 2.3-2.5%. At the March FOMC meeting earlier this year the Summary of Economic Projections (SEP) reported longer run growth prospects were believed to be only 2.0-2.3%.
Some argue that because of this reduction in expectations for potential output, the Fed has greater leeway to firm its policy stance under slower than once assumed growth conditions. If correct in assuming the potential growth is as low as 2.0-2.3%, Fed officials must also be prepared to accept that they were, for a time, running a more accommodative policy stance then they had earlier imagined.
Unfortunately perhaps, the outflow of that greater than intended level of accommodation has not to date brought about consistently above trend growth levels. And while current year over year and projected growth over the next year are considered by the Fed to be above trend relative to latest SEP, there has been no meaningful rise in inflation thus far. It is likely therefore that either potential growth is higher than the Fed’s 2.0-2.3% longer run expectation or that there are latent but building inflationary pressures. At this juncture however, with the fresh memory of weak Q1 growth, a greater majority would instead highlight the fact that despite higher than anticipated levels of monetary policy accommodation over the last years, neither growth nor inflation has yet achieved critical levels.
It is difficult to remain encouraged by the additional repairs to household balance sheets and to the abundance of cash on balance with businesses. These strong positions suggest the ability to generate invigorated spending and investment levels, thus raising growth and employment conditions. A late arrival of the beneficial impact from improved balance sheet conditions however, may find their eventual appearance a surprising event and not without some positive adjustment to growth, employment inflation expectations.
There has been considerable and likely exaggerated concern about the prospects for a spike in long rates following a Fed announced rise in the fed funds policy rate. Many point to the mid-2013 ‘Taper Tantrum’ as reason to be concerned. Others, more correctly recognize the reduced presence of bank positioning as a likely contributor to future periods of market illiquidity.
We should remember that when then Fed Chairman Bernanke spoke of removing the securities purchase program in mid-‘13, he did not indicated any ‘policy-path’ for that accomplishment. As a result, confusion and concern brought about by that unknown led to an exaggerated reaction. Note that when the Fed in December of that year laid plans for a ‘program’ of steady reduction to that purchase program, the reaction to the news was minimal.
On the approach of the first policy rate adjustment in more than 6.5 years, the Fed has made clear that the process of removing accommodation should be expected to be abnormally slow. This assurance will help to limit the reaction to the initiating of the firming of the policy rate. Although the Fed is not providing exacting detail for the timing and measurement of accommodation removal as it attends to its ‘data-dependent’ approach, we have been given strong assurances that no abrupt policy firming should be expected in the near-term.
An articulated ‘policy-path’ for the tapering of security purchases helped to prevent an over-reaction to a tempering of additional accommodation back in 2014 (For further discussion on ‘policy-path’ see (http://thefedandinterestrates.blogspot.com/2014_01_01_archive.html). At present, the long-standing Fed assurances that ‘even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run’, should prove supportive once the Fed begins raising the fed funds policy rate.
Until more recently, I had expected the Fed to move forth with its initial reduction in monetary policy accommodation by raising the fed funds policy rate at this June FOMC meeting. While, I still believe that to be the best policy decision, the recurring distraction from another single winter quarter of weak GDP however has likely contributed at least an additional modicum of caution on the part of FOMC participants that will leave them prepared to postpone the initiation of policy rate firming.
We advise listening carefully to clues that would place the July meeting more squarely on the table for the first policy rate move. This is the main risk that attends this meeting. The market has priced less than 2 policy rate firming (of 25 bps per) for this year. Should market participants come to give greater expectation to a July start for policy firming, the front end of the yield curve could have a significant adjustment. At the same time, we would ready in the event there is an excessive over-reaction out the curve to such news as this would provide additional positioning opportunity.
Finally, some economic agents have become sensitive to the reduced level of liquidity in the fixed income markets as Basel III initiatives have caused banks to scale back participation. As a likely offset to this reduced bank participation, we should expect that the initiation of reduction in accommodation, will itself provide some benefit from increased policy transparency. Currently with policy neither increasingly more accommodative nor reducing the level of accommodation, economic agents are less willing to move forward with spending and investment plans until such time as a more confident assessment can be made about the future for policy rates.
Counter-intuitively, even a small move forward in the process of policy firming could provide a boost to economic growth as economic agents become more confident in their assessment of future policy rates. Especially at current low levels of policy rates, a greater conviction on the part of economic agents in their ability to forecast forward rates should be expected to outweigh the impact from marginally higher policy rates.
‘Importantly, it is not necessary that all economic agents agree on expected policy path in order for the Fed to engender economic support from forward guidance. By providing enough information to allow economic agents to gain greater confidence in their expectation for policy prescriptions, the Fed will induce these same agents to take on greater levels of risk as matches their greater levels of certainty.’
At This Meeting
- 2015 GDP growth likely to be lowered from 2.3%-2.7% in SEP
- Current economic outlook to be upgraded in Statement
- Expect more forceful acknowledgement that ‘Every Meeting is Live’
- SEP 2015 Year-End fed funds still 0.63%