Wednesday, May 02, 2018

FOMC Report May 1-2, 2018

Executive Brief
The Federal Reserve is expected to refrain from changing the fed funds policy target range from 1.5-1.75%, where it was adjusted to in March.  There is no scheduled update for economic projections nor is there a post-meeting press conference.  There may however, be some policy tweaking suggested in the Statement following the meeting.  Specifically, there may be some upgrade in the assessment of inflation and the prospects for inflation meeting its target.  At the same time, the release may downgrade the following statement on growth; ‘The economic outlook has strengthened in recent months.’

Focus Shift – Growth to Inflation
A most striking change appears be occurring within the last few weeks.  Many economic agents seem to have come to regard inflation rather than economic growth as the likely primary driver for Federal Reserve policy over the coming months.  Where it once stood that economic growth at or above its potential would drive inflation toward its mandated 2%, now attention is more specifically focused on inflation, suggesting it has largely achieved its requisite and as such is the basis for monetary policy guidance.  Concern for some has now shifted to, ‘what shall the Fed do if inflation continues strong in the absence of economic growth at potential or above’.  It will be interesting to learn how, if at all, the FOMC Statement indicates that participants there have altered their focus. 
Possibly more interesting to others is how policy focus could have changed while very little in the way pricing of the Feds projected policy path has itself changed.  It seems highly unlikely that the premise for policy directive could change as earlier described while US Treasury yields have remained largely unchanged from where they were at the last FOMC meeting. 
For many months the message from the Fed has been that the pace of projected economic recovery will be sufficient to insure that the inflation goal of 2% will be satisfied in the not too distant future.  This message had become rather tiresome to hear as repeatedly the actual inflation outcome was below Fed projections.  Growth prospects have long been the cornerstone for Fed policy as that half of the dual mandate found some success.  Economic growth was repeatedly counted on to provide the impetus for change in the policy rate, ever-assuming that progress on inflation was forthcoming. 
Weak price components like cell phone charges and lower energy costs have begun to fall from the monthly inflation reports.  Reports of late have become more consistent with recognized inflation prospects in a recovering economy which has performed above its potential for some time.  For a multitude of reasons unfortunately, economic output and expenditures have started to fall off just as inflation has neared its Fed goal. 
Without hesitation, many economists are now eager to discuss the prospects for ‘stagflation’ or some such variant of higher prices combined with lackluster growth.  There would be more serious reason for concerns of stagnation potential if it were not for remaining excess capacity to produce and still large global slack in the workforce.  However, should an extreme of the proposed tariffs discussed by the Trump administration come to represent policy, and as a result other-sovereign retaliatory measures enacted, we might find additional excess capacity, higher domestic prices and idled equipment and workers.   

Policy Directive and Policy Cycles
If focus changes from growth to inflation so too may the Fed’s policy directive shift from a ‘path dependent’ nature to a ‘data dependent’ one.  While acknowledging the Fed as being ‘data dependent’, we know full well that if growth is present and inflation is assumed to be achieved with a lag, the Fed can remain on a consistent policy course until such time as the inflation catches up or economic growth weakens.  We describe a policy consistent with that frame of reference as being ‘path dependent’.  Such a policy directive is insulated to a large extent from the general noise associated with mid-cycle economic data.  In other words, the Fed need not react as quickly to data which is inconsistent with steady progress toward its inflation mandate in the face of irregular growth.  In this most recent case, the Fed has had the luxury of enjoying above potential growth while inflation has been extremely slow to catch up.  This might be considered the most desirable of the possible combination where one or both of the dual mandates is not at target.   
Under a purely ‘data dependent’ policy directive, where both economic performance is at its maximum sustainable pace and inflation is near its 2% target, the Fed no longer has the ability to provide the guidance it was once able to offer.  It is required to be on guard for either of the dual mandates to stray from target which could provoke a policy response.  Unfortunately, maximum employment and stable 2% inflation is not a steady state environment.     
This suggests that the tepid level of volatility seen over the last two or more years may come to an abrupt end and economic agents will be required to ‘think on their feet’.  Many once insignificant variables - economic data and geopolitical events will have the potential to influence asset prices more severely than had been the case when the Fed was in ‘mid-cycle’ – a ‘path dependent’ directive. 

For now, the Fed is scheduled merely to offer a statement of policy guideline with an interpretation on the forces driving growth and inflation.  We suspect inflation conditions and its outlook will be upgraded and the expectations for strong economic growth will find some qualifications.  At the March FOMC meeting both staff and participants noted economic growth prospects were in excess of that expected as recently as the December meeting.  It appears as if those brighter growth prospects may be described as less certain in the FOMC statement accompanying this May meeting.  Finally, we have suggested that the Fed is moving closer to a more fully ‘data dependent’ policy directive for the first time since late-2006.  As such, the expectation is for volatility to rise as an increasing number of variables and events could more strongly influence perceptions for the direction and extent of policy initiative.    

Closing Thought
It remains widely assumed that the U.S. fiscal package passed, which includes some lower taxation from wages for the working class, will promote additional spending of that new discretionary income.  It always appears the easy wager to bet against the average working stiff.  He is assumed to go blindly where directed and to perform, ‘at average’, in accordance with prevailing economic theory.  In this case, he is widely assumed to misinterpret the deficit causing condition these most recent tax and spending plans have encouraged and instead and with utmost ignorance he will promptly spend the extra coinage, presumably burning a hole in his pocket.  As someone who enjoys being a student of economic theory, I need to guard myself against this kind of thinking.  Given the timing of the most recent tax and spending changes relative to the position within the economic cycle, it appears that a modicum of caution is called for.  Caution is advisable on the part of those who would predict spending habits and by those with a few extra coins in their possession.  Might ‘average Joe Six-pack’ sense these conditions even if he is unable to name exacting economic theory?    

Tuesday, March 20, 2018

FOMC Report March 20-21, 2018

Executive Summary
The Fed is expected to raise the fed funds policy rate by 25 basis points to a target range of 1.5-1.75% at this FOMC meeting.  Further, the FOMC statement is expected to again indicate that ‘the labor market has continued to strengthen and that economic activity has been rising at a solid rate.’  Additionally, we expect the Fed to advise that ‘near-term risks to the economic outlook appear roughly balanced’. 

The statement, the press conference and the reply to questions thereafter are all likely to be slightly more hawkish than is the Survey of Economic Projections (SEP).  In short, the Fed will allow the market, if it chooses, to start pricing the prospects for 4 rate hikes this year, but it will not push it to do so.  The Fed is not expected to plot more than 3 dots for 2018 on the SEP.  The Fed is instead expected to show 3 dots for 2018 and 3 dots for 2019 (from 3 & 2). 

Further Gradual   
Over the last few years the Federal Reserve has provided a rather straight forward view of the path for monetary policy.  The prevailing catch phrase used to describe policy implementation has been ‘gradual pace’ of accommodation removal, which dates to the December 2015 FOMC meeting.  Currently, gradual pace is widely believed to mean three, 25 basis point policy rate hikes a year. 

At the January FOMC meeting, the Fed added the word ‘further’ in front of ‘gradual pace’ in describing the course for monetary policy.  This caused a lot of excitement.  There remains some uncertainty as to whether the ‘further’ implied a step-up in the pace of accommodation removal or that the current pace of policy firming might be expected to last longer than earlier imagined.  For now, I’m leaning toward the latter interpretation.  This in part, is why the Fed is expected to adjust the 2019 dots from 2 to 3 rate hikes.  

Path to Data Dependent Risk
As the Fed adjusts to incoming data and judges the progress on the attainment of their dual mandate goals they will inevitably need to square with the notion that they cannot provide as much guidance as had been previously allowed.  One of the greatest benefits to being in the middle ground of monetary policy cycles is that it allows the Fed an opportunity to provide extensive guidance.  During mid-cycle the Fed can indicate a ‘path dependent’ approach to monetary policy implementation.  We may be pushing against the later edge of this mid-cycle monetary policy phase. 

At some point, the Fed will be required to react to growth beyond potential, inflation above its objective or excessive leverage which has caused great distortion to asset prices.  As this happens, the Fed will be forced to move to a data dependent regime and thus become 0unable to offer the guidance it once could.  Market volatility rises as the Fed moves to a data dependent regime while the ‘time lag’ between policy initiation and its effect on the economy collapses. 

As we saw in late-2016, once the Fed moved away from its ‘measured pace’ (aka ‘gradual pace’) to a data dependent mode of operation, the time lag for the earlier rate hikes narrowed and became at once a powerful drag on economic growth.  Currently, the Fed is toying with the catch phrase ‘gradual pace’.  If economic agents come to expect the Fed is moving away from a path dependent frame of operation to a data dependent and reactive approach, there will be great changes afoot.   We would of course expect greater volatility under less Fed handholding.         

Tuesday, January 30, 2018

FOMC Report January 30-31, 2018

Based on current conditions, we might expect historians to write favorably of Janet Yellen’s tenure as Chair of the Federal Reserve which comes to an end shortly after this meeting.  Yellen was handed the reins immediately following the announcement for the reduction in the scheduled purchase pace for the third in a series of quantitative easing programs which had eventually brought the size of Fed balance sheet toward $4.5 trillion. 

During her time, the Fed has been able to move the fed funds policy rate above the successfully defended zero-bound five times, to its current target range of 1.25-1.5%.  The last rate hike or what the Fed has preferred thus far to view as a ‘reduction in accommodation’ was conducted in December.  That December 2017 adjustment was the third such of the year which brought the policy rate in line with the Fed’s own late-2016 stated expectation (SEC dot plot) for year-end policy rate.  While the Fed had not always offered such a forecast, it is quite clear that the Fed had until last year, not been able to ‘guess’ a next-year-ending policy rate in more than a decade. That last time was of course when the Fed was finishing its ‘measured pace’ experiment.    

As indicated in my last FOMC report (‘FOMC Report December 12-13, 2017; Are We Again Seeing Malinvestement’), there is a little known or lesser appreciated risk in the Fed providing a somewhat predictable policy path for rates.  The nature of risk assumption is changed when a highly visible central bank policy prescription is viewed as and for a time proves to be extremely predictable.  Especially at historically low levels of interest rates, we should expect that the confidence built from a ‘known’ or perceived knowable policy path for rates will encourage leverage and speculation, even when that path for rates is higher. 
Since 2015 and the start of accommodation removal, financial conditions have actually gotten easier.  It is only recently that the move toward easier financial conditions has slowed.   A predictable pace of Fed policy path has contributed to this development.  Starting in October the Fed has added another policy path that is predictable.  The reduction in the Fed’s balance sheet is to be very gradual and is well defined.  While this policy path too adds to the known policy prescriptions, its influence on leverage and speculative interest is not expected to be that great.  Finally, the slow reduction in longer-date Treasury securities will not prove too much pressure on long bond yields as the Treasury is expected to make up the Feds absence mainly with Treasury bills and shorter maturity notes. 

The FOMC Statement   
The Fed is not expected to change the fed funds policy target rate from current 1.25-1.5%.  

The Statement may phase out references to hurricane-related fluctuations and note a strong (3.8%) increase in Q4 consumer spending, indicating more generally that economic activity continues to grow at a solid pace. 

Concern shown for below targeted inflation may be reduced as survey-based measures as well as underlying have recently improved. Still, the statement is likely to continue to advise that the Fed will ‘closely monitor(ing)’ inflation developments.    

The statement will likely still indicate Fed expectation for a ‘gradual adjustments in the stance of monetary policy’. 

The Fed could adjust the near-term risks statement from ‘roughly balanced’ to balanced, but to do so, they also risk a more complete pricing of the three rate hikes the most recent (December) SEP has called for this year.  Already, roughly 62 of the 75 basis points the ‘dot plot’ projects have been priced.  The Fed might not be in a terrible hurry to see the market out-price their projected path.

On Expectations and Surprises
Below is a chart that I have become fond of over the years as it has provided ample warning for conditions which indicate that too much or too little exuberance is afforded the prospects for US economic development.  The chart is of the Citibank Economic Surprise Index and it shows that from a low point in mid-2017 (negative 78.6), economists as a whole had regularly provided forecasts which were exceeded by actual output.  That trend continued until recently (See ‘Have Growth Expectations Gone Too Far?’) when in late-December, economists had apparently come full circle and began to believe the economy was doing better than it actually was.  You see that over the last month, the index has declined from 84.5, a high not reached since 2012, to 35.5 currently, indicating they have now regularly overestimated economic activity

While there is a growing acceptance that global growth is in sync and improving, underlying that improvement is an even greater anticipation for what is possible on economic output.  There appears to be some room for expectations to be curbed further.  Whether that results in a 'hiccup' in the move toward higher US Treasury yields is still to be seen.  Currently, attention is heavily focused on all things pointing toward a step-up in the pace for Fed accommodation removal and strengthening global economic output.