Tuesday, March 18, 2014

FOMC Report March 18-19, 2014

The latest challenge for the Fed just got a little easier.  The unemployment rate that had been declining rapidly toward the ‘Evan’s Rule’ threshold guidance level of 6.5% eased back from 6.6% to 6.7% at the release of the February employment report earlier this month.  As the unemployment rate moved more quickly than expected toward that threshold over the last months, Fed officials made clear it was not a trigger and that other variables were being considered as a guide to when monetary policy would become less accommodative.  However, the guidance provided by that 6.5% unemployment threshold has been lost and there is little reason to continue its use.  The Fed is interested in advancing an alternative guidance that will offer support for economic progress by strongly discourage economic agents from pricing too-soon a lift-off for the fed funds policy rate. 

The Fed will in all likelihood simply drop the reference to the 6.5% unemployment rate, otherwise leaving much of the same message as before.  They could provide additional insight as to particular economic and financial measures considered, but they would not want to get too bogged down with specifics. Instead, simply being able to point toward a varied collection of economic and financial market performance measures and further being able to note those measures are not yet at levels where the Fed would consider removing accommodation could be a powerful message.  Such language could be used until just before the Fed chooses to lift policy rates.  

Few if any believe the Fed has any intention of raising policy rates before the tapering of asset purchases is completed late in the third quarter of 2014.  Fed statements have led most of the more hawkish Fed watchers to believe that the Fed would not raise fed funds policy rates for a minimum of three to six month following the completion of asset purchases.  Still, the Fed would like to have the market price that event further out in the future in order to continue to promote stable and low long-term Treasury yields. 

Efforts to promote expectations for a more distant lift-off date using the FOMC statement change that drops the 6.5% unemployment threshold guidance and replaces with qualitative guidance can be further supplemented by reference to the Summary of Economic Projections (SEP).  Some have argued that SEP values be used within the context of the FOMC statement to provide rules as to when the Fed should be expected to change policy.  Such use of SEP information not recommended as it may raise creditability concerns.  However, Fed Chair Yellen could discuss in the post-meeting report and Q&A the value of relying on such projections to recognize FOMC participant’s understanding of future values for policy rates and other economic variables. 

Expectation for longer-run real GDP and fed funds policy rates add insight into future long-term Treasury yields.  There has been a steady decline in the Fed’s (SEP) forecast for longer-run real GDP.  In January 2009 as the Fed moved to provide more formal quarterly updates for economic variables in the form of the SEP, Fed participants provided a central tendency forecast for loner-run real GDP of 2.5 to 2.7%.  This longer-run central tendency forecast was increased to 2.5-2.8% in November 2009 and remained at that level until November 2011 when it was again reduced to 2.5-2.7%.  Central tendency expectation for real GDP has steadily declined since.  In December the upper bound of the 2.2% to 2.4% range was below the lower bound (2.5%) from two years earlier. 

Clearly expectations for longer-run growth have been scaled back.  So too have expectations for longer-run ‘appropriate’ fed funds policy rate.   Starting in January 2012, the Fed began providing quarterly updates in the SEP for year-end value for fed funds policy rates expected over the next three year, as well as the expected longer-run policy rate.  The average of the participant’s rate projections has steadily declined from a starting value of 4.21% in January 2012 to 3.88% at the most recent December 2013 update. 

*Missing Chart of Longer-Run Policy Rate Forecast

The SEP has additionally provided information about the expected path for fed funds policy rates over the coming three years.  Since it has been providing such data, the participant’s expectations for the year-end value for policy rates in coming years has consistently been marked lower.  We should expect the upcoming SEP that accompanies the March 2014 FOMC meeting to show still lower expected rates in future years.  At least one of the two participants who in December had higher rate forecast for 2014 is expected to move that expectation to 2015.  Additionally, one or more participants may also move from 2015 to 2016.  The chart below shows the average year-end rate forecasted by Fed participants at the last 4 quarterly updates for SEP. 

We should expect to hear additional references to the declining trend of expected year-ending and longer-run fed funds policy rates over the coming months as it will help to support the Fed’s goal in limiting the increase in long-term Treasury rates as the Fed completes its purchase plans.  It may be the cleanest form of support for policy intent.  

Missing Chart of Year-Ending Policy Rate Forecast  
On Weaker Data and Tapering

The Fed’s Beige Book made clear that Fed officials had difficulty reconciling economic progress as a result of challenging weather conditions.  The report made reference to weather 25 times within the summary alone.  Still, there are some who believe some more fundamental slowing of the economy is evidenced in the data over the past months.  The Fed however is not prepared to react hastily, but instead should be expected to continue on its present course of tapering.     
Tapering of securities purchases has been moving along smoothly and we are left to expect the Fed will continue to reduce the level of monthly purchases by a ‘measured step’ reduction of $10 billion per FOMC meeting.  Fed officials have made repeated remarks about there being a ‘high bar’ for changing that pace.  You are invited to review my last FOMC report for a more detailed discussion of the ‘policy-path’ implications of tapering.  We might note here however that the main difference between the mid-’13 declaration of tapering intent and the December ’13 FOMC implementation of that intent was the stated path for tapering with strong implication for the level increment.  In the absence of that ‘policy-path’ expression, the mid-’13 discussion of tapering found only sellers of Treasuries and a jump in term premium.   

*if you would like a pdf copy that would include the charts, contact me at edtechmm@gmail.com
and I will send to your email.  

Monday, January 27, 2014

FOMC Report January 28-29, 2014

Last year at the January 2013 FOMC meeting the Fed took a breather following the significant policy changes that took place at their December 2012 gathering. We should expect the Fed to again leave well enough alone at this weeks meeting.  Last year the Fed paused in January after having added longer-term Treasuries to their open-ended agency mortgage backed securities purchase program and initiated ‘threshold’ guidance for policy rates.  This December just past the Fed announced the start of a tapering of the purchase program offering forward guidance on the path for tapering while providing further qualitative guidance for the policy rate.   

The weaker employment report earlier this month came at a relatively opportune time for Fed policymakers.  Had that report come a month earlier, it may have caused a delay in initiating a scaling back of securities purchases, causing increased concerns about the programs efficacy.  The Fed did announce tapering plans at the December meeting, met thereafter with declining Treasury yields as economic agents were heartened by an understanding of the a policy-path description in the taper plans (see ‘Unconventional Policy Guidance; Then and Now’ below).  
(see also ‘FOMC Report December…’ for further discussion)[1]

Treasury yields fell further after a low December non-farm payroll release.  In addition to the modest effect weather played on the December payrolls, reports of excess inventory accumulation early in Q4 spooked managers prompting more cautious hiring practices later in the quarter.  Fiscal policy debates were also disruptive to hiring plans. Although sever winter weather persists, strong private domestic demand has eased concern for inventory overhang while fiscal policy distractions have abated. 

Rarely are economic disruptions seen as a plus by monetary policymakers.  In this instance however, the lower Treasury yields resulting from the weak December payroll report and the recently equity market pull-back leave the Fed apt to accept the potential economic benefit from these lower Treasury yields as a gift not paid for in greater levels of monetary policy accommodation.  We should therefore not expect either the lower payroll number or equity weakness to dissuade the Fed from following their ‘policy-path’ for per-meeting taper plans.    

Unconventional Policy Guidance; Then and Now

At each application of LSAP, Treasury yields reached a nadir at or shortly after a programs announcement.  In each of these purchase programs, details about the size of the program, period specific application and in most cases its ending date allowed economic agents to construct a present value for the policy impact.   The ability of economic agents to discount the benefits of the purchase programs resulted in the lowest yields being found at or near the announcement of the program.  Thereafter, while economic benefit continued to be derived and the application of the purchase program continued to offer support, the impact on Treasury yields diminished throughout those programs in accordance with the discounted nature of that support. 

I have argued that recognition of monetary policy path by economic agents can result in a powerful economic support.  Where this understanding of policy intent is quantifiable and discriminates along a timeline, economic agents are capable of discounting the present value of that support.  The ability of economic agents to discount the expected benefit from clearly defined LSAP programs is believed to be the reason why Treasury yields reached their lowest levels at or near the start of these programs.

In keeping along these general lines and bringing this theory closer to today’s situation, we might consider the implications for economic agents understanding the policy intent in ‘measured steps’, as described in the December FOMC statement, ‘the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings’[2].  The Fed has afforded economic agents a timeline with discrete intervals (FOMC meetings) and a likely interval value $10B reduction in purchases.   The language ‘further’ helps to describe the December FOMC announced $10B reduction in purchase plans from $85B to $75B as ‘the’ example of ‘measured step(s)’.

With great confidence then, economic agents can build-out to very exacting detail the likely policy path for tapering of the purchase program.  By outlining this policy path, the Fed has been able to partially offset a negative reaction to a reduction in the purchase program.  To the extent that the purchase program was already largely expected to be removed, the Fed’s forward guidance for the purchase plan could have had a net bullish effect on Treasury prices.  However, just as economic agents were quick to discount the value of LSAP programs at announcement, we should expect that the benefit, in lower Treasury yields from this ‘know’ policy-path of tapering has also been discounted.  All else equal, we should see yields rise as time passes as the benefit from the known policy-path for tapering is realized.

In the current situation as regards the tapering plans, economic agents largely share the same basic outline for how the Fed will proceed.   There are certainly some who differ in their opinion as to how the tapering might proceed.  However, a strong majority expect the Fed to taper at $10B per meeting and to wrap the program up around October this year. 

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. 

Policy Direction from this Meeting

  • On Overnight Reverse Repo Program (ON RRP);The Fed has been successful in testing this policy instrument that will one day hold an important place in matching the need for control over excess reserve balances with the target policy funds rate.  The trial period is scheduled to conclude on January 29, but overwhelming support for an increasing the per-participant daily allotment from $1B to $3B at the December FOMC meeting leaves little doubt of support for the ‘testing’ period to be extended.  The ON RRP is unlikely to find any idle time, instead it will eventually elevate it to active policy status when the need is apparent.   The Fed will take care over the coming quarters not to excite unintended suspicions of restrictive policy intent in further testing of this program. 
  • No change expected in ‘policy-path’ guidance for tapering.
  • No change expected in policy rate guidance.
  • Possible upgrade in statement about current economic conditions.   

[1] http://thefedandinterestrates.blogspot.com/
[2] http://www.federalreserve.gov/newsevents/press/monetary/20131218a.htm

Monday, December 16, 2013

FOMC Report December 17-18, 2013

Policy Options

The difference between the September FOMC meeting and the upcoming December meeting lies in the strong expectations for a tapering announcement at the September meeting but currently there is no consensus expectation for the outcome of the December meeting.  There are plenty of guesses as to what, if any, policy change(s) the Fed may offer but few have professed a strong confidence in their predictions.

Leadership changes at the Fed offer further challenges as to what policy changes, if any, might smooth a transition to a new Chairperson.  There may be an agenda for the retiring Bernanke who might want to begin the tapering before stepping down.  Additionally, confidence for a tapering announcement at this meeting is lacking because most recent inflation reports show no clear movement toward targeted 2% even though expectations still point toward achieving that level in the intermediate term. 

Some however argue the time has come to pare back on unconventional accommodation pointing toward stronger and likely sustainable employment growth.  Additionally, current retail sales data suggest that some of the recently higher than expected inventory build may be worked off sooner than anticipated, driving current and quarter-next growth estimates higher. 

Other advocates of tapering have grown more vocal about efficacy concerns.  The Fed, as seen in the minutes from the October FOMC meeting, had become sensitive to a need to communicate appropriately a scale back of the purchase plans if as result of reduced efficacy.  It was furthered that some replacement support might be appropriate if efficacy rather than satisfactory goal progress was the reason for tapering.

There have been a number of ideas floated that the Fed might consider in an attempt to provide additional support for reaching its full employment and stable, but higher levels of inflation goals.  Many have come to expect one or more of these potential supports especially if the Fed chooses to taper its purchase program.  

First, there has again been a call for consideration of lowering the interest paid on excess reserves.  Few Fed officials however have voiced support for this while a strong majority at the Fed would not expect meaningfully positive nor asymmetric advantages from lowering that rate.  Many argue that banks do not need to be induced through a lower excess reserve rate to search out qualified borrowers, but that qualified borrowers already have sufficient funds or access to funding.   

Secondly are the proponents for a lowering of the employment threshold guidance from 6.5% to 5.5-6%.  Good argument against this approach has always been that any lowering of the employment threshold could either confuse or create an unwanted creditability risk.  However, a year has passed since the initiation of threshold guidance and we have since learned much about the temperament of the participation rate and more encompassing employment gauges. 

There would also be those who would look for the Fed to announce a lower bound for the inflation threshold which supporters note could prescribe policy rate remaining at the zero bound for a minimum of an additional quarter following an employment threshold breach.  The Fed has however already made clear the goal of 2% inflation and for many there is no need to spell that out further.

Aside from the weak call for a lower excess reserve rate all the above options for additional support are tied to forward guidance for policy rates.  Instead, the best form of policy rate guidance available at this juncture does not include the manipulation of threshold guidance but rather would use the quarterly Summary of Economic Projections (SEP) which Fed participants will submit at this meeting.  If the Fed is intent on impressing a likely liftoff date no sooner than mid-2015 the easiest and least costly way to express this is in their Summary response to ‘appropriate timing’ and ‘pace of policy firming expressions’.

Post-Taper Support Absent Forward Guidance

The Fed’s greatest communication challenge of late is its inability to separate the announcement of tapering plans from implication for liftoff date for the fed funds policy rate.  Generally speaking however it is fairly clear that any movement from higher to lower levels of Fed accommodation, be they in the form of tapering (unless for efficacy reasons) or adjustments in policy rate will only come about as a direct result of progress toward Fed mandates.  The Fed cannot expect economic agents to disregard this linkage so any distancing of these policy tools has to come from elsewhere.  In order to reduce the chances for the market participants bringing forward the implied policy liftoff date following the announcement of tapering the Fed must create distance wherever possible in discussion, but also clearly in implementing changes in these policy tools.

It is too late to take back recent Fed official statements that mentioned within the same sentence, possible future plans for both securities purchases and changes to the policy rate.  This is not an issue at this meeting if the Fed decides not to taper.  While in the future Fed officials could take greater care to separate their discussions of these variables, efforts to date are insufficient in preventing economic agents from pricing nearer expectations for the policy rate liftoff date.      

Despite this recognized Fed communication challenge, many still expect additional forward guidance measures to be initiated concurrent with a taper announcement so as to temper market reaction a standalone taper announcement might bring.  It seems rather intuitive however that if the Fed hopes to avoid policy rate liftoff creep, it should make every effort to keep implementation of taper plans separate from any forward guidance change.

If the Fed decides to begin tapering, but wants to afford some replacement support it should consider adding reference to a timetable for removing the purchases entirely.  Dallas Fed Fisher suggested the same in a recent speech in Chicago on December 9th.  A pace of tapering implied or explicitly expressed by the Fed consistent or slower than market participants otherwise might fear would provide support from the higher absolute ending balance of SOMA portfolio to be expected.  Additionally, by announcing explicit plans for a tapering schedule or by providing enough information to allow economic agents to confidently build-out their own schedule expectations, the fed would provide a ‘path’ for policy intentions. 

A recognized path for policy intentions can offer strong support at little cost to the Fed.  Especially at inflection points in Fed policy, communicating a path for policy tools can reduce the stress on the economy associated with heightened uncertainty.  The Fed should wherever possible during accommodative policy intent make use of opportunities to spell out policy path to take advantage of resulting economic support. 

Another form of replacement support the Fed might consider when announcing tapering plans is to make explicit an intention to maintain or hold onto securities within the SOMA portfolio out to some distant calendar date.  Although it has become more widely expected the Fed will have no plans over the intermediate term to reduce its portfolio through outright sales, an explicit announcement of such intention would likely provide some support.  

Policy Change Expectations

Because of the misunderstanding of Fed intentions in front of the September FOMC meeting, it is difficult to place any great confidence in what the Fed might do at this meeting. My expectations are however for the Fed to announce tapering plans to start in January at a pace of $5-10 split evenly between Treasuries and agency mortgage- backed Securities.  I expect the Fed will provide some guidance, possibly quite specific in projecting a purchase end date toward September of 2014.  The Fed will leave the purchase program ‘open-ended’ and continue to assert the ‘pace (of asset purchases) will remain contingent on the Committee's economic outlook as well as its assessment of the likely efficacy and costs of such purchases.’    

The Fed could, but is not expected at this juncture to indicate a specific reference date before which no outright sales from their portfolio should be expected. 

The Fed should be expected to refrain from changes in its threshold guidance or changes to the rate paid on excess reserves.      

Tuesday, October 29, 2013

FOMC Report; October 29-30, 2013

It appears that the Fed’s attempt to ready economic agents for a reduction to the level dose of additional monthly accommodation had gone terribly wrong.  Though a heavy price was paid that the Fed might better understand the reaction function to tapering plans, it is difficult to see how this information was used, except possibly to have scarred Fed officials from following through with those plans.  Had the Fed been able to follow more immediately from the May 22nd Congressional testimony with a small decrease in monthly purchases, the economic backdrop might look more solid today.                                                             

Of course a majority of Fed watchers were found believing that the Fed was prepared to begin tapering at the September FOMC meeting.  Many recognized that economic growth and labor market conditions were not so strong as to make the case for tapering easy.  However, the Fed having made transparency of monetary policy intent a priority, failed to dissuade this majority from their expectations. 

Without doubt the Fed had made clear that economic growth needed to continue to proceed apace if they were to follow through with tapering plans.  As such, market participants followed economic developments and collectively arrived at the conclusion the Fed had enough reason to begin tapering.  This was expressed by a majority of Fed watchers and indicated further in numerous well-followed surveys.  

It seems likely that it was only when the Fed met on September 17-18, that they came to the conclusion it would be better to spend reputational capital in the form of lost creditability for mistaken transparency than to risk the unknown of taper roll-out.  It is difficult to believe that Fed officials intended to surprise economic agents with a no-taper move in order to create the sharply lower bond and mortgage yields that immediately followed.  That would of course goes against any notion of transparency.

Still, the market was surprised by the no-taper decision with the rate and equity markets reacting immediately and forcefully.  Bernanke has said that the Fed’s level of transparency can be gauged by the extent markets move following the release of the Fed’s FOMC statement.  Clearly, the Fed would be judged opaque of late.

At the time of the May 22nd Congressional testimony which laid out a general guideline for tapering to begin by year end, it was suggested here the announcement was an opportunity to better understand the reaction function for taper news.  To this we further suggested the Fed may have paid a rather substantial upfront premium, in the form of higher Treasury and mortgage yields and lower equity prices, for volatility protection in the future.  

Instead, enough time has now passed that the reaction function to taper news has changed from that understood back in May-June.  We could however argue that the more recent response to the no-taper announcement at the September FOMC meeting updates the Fed’s understanding to this reaction function.  Still, it is reasonable to be concerned about the impact on the economy from these major market adjustments in what some might consider a monetary policy misstep.

Rather than helping economic agents gain confidence by providing valuable insight into policy intent, the Fed has reduced potential economic growth by adding to market volatility around economic releases.  Going forward, economic agents will still be required to analyze additional months of economic data, suffering again the volatility at economic releases in order to again guess when the Fed has seen enough strength (or decreased efficacy) to warrant tapering.  All the while, would-be spending, hiring and investment plans await greater visibility.     

It is difficult to know with any great confidence what damage was done as a result of monetary policy missteps combined with fiscal folly, in the form of budgetary and debt ceiling impasse.  Monetary and fiscal policy-generated uncertainty may have prevented the economy from gaining sought after escape velocity.  However, unless the damage to economic prospects is more severe than apparent in the data released over the last weeks, there is good reason to expect that the current low yield environment combined with additional amounts of treasury and agency mortgage backed securities purchases (despite increasingly diminished efficacy) will help position for stronger growth again by early 2014.  

For the October FOMC meeting, we should not expect any tapering announcement or guidance change.  There may be a reference to recently softer labor market conditions though the outlook for the labor market will likely remain positive.  The FOMC statement might also reference the fiscal budgetary and debt ceiling impasse as having contributed to higher levels of uncertainty and softer growth.