Friday, October 23, 2015

FOMC Report October 27-28, 2015; Leave the Door Open

Leave the Door Open

There is little reason to expect the Fed will adjust its policy rate at this October FOMC meeting.  If economic output since the September FOMC meeting had been slightly more robust and if the late-August financial markets disruption had more immediately and fully repaired, the October FOMC meeting would have presented a good opportunity for the Fed to begin removing monetary policy accommodation.  As it is, Fed officials are likely to collectively assume there is more to be gained from assessing for a bit longer the potential fallout from slower global growth and a possible step-down in the pace of domestic job growth.

While the markets are currently pricing a greater chance for monetary policy normalization to begin in 2016, my analysis still suggests the December meeting is a better likelihood.  Before the December, 2013 FOMC meeting few, for a variety of reasons, believed the Fed would change its stance on security purchases.  I argued before that meeting that the Fed would announce a reduction of purchases to begin in January (2014), describing a pace for the elimination of purchases by the 4th quarter 2014 (FOMC Report December 17-18, 2013).  Market participants may again be mistakenly expecting that the Fed will wait till ‘next year’ to move forward.

However, at the September FOMC meeting just past, a large majority of FOMC participants (13 of 17) indicated that they expected the policy rate to be higher at year-end.  While employment growth has continued, though at a slower pace – possibly as a result of some slack already having been removed from the labor market, other signs of moderation are expected to keep a majority of voters from electing to move in October. 

A reduction in output has been accompanied by a reduction in inventory levels that may prompt some re-shelving of inventories in Q4, elevating growth above potential once again.  Otherwise, the housing market continues to improve and consumer spending has held up well. 

In describing economic growth in the statement following the meeting, the Fed may choose to indicate that the pace has been ‘modest’ rather than ‘moderate’ as they had in September.  I suspect they will choose to continue to use the ‘moderate’ description and possibly note that the slowing in employment growth is consistent with the removal of slack in labor markets thus far and that the cumulative improvement has been encouraging.  Otherwise, the use of the term ‘modest’ to describe growth might suggest there is a lesser chance for a December policy response.  The Fed looses nothing in keeping its options open for December.    

In further acknowledging the cumulative gains in labor market conditions, the Fed might change their guidance language.  Instead of indicating ‘when it has seen some further improvement in the labor market…’, it may adjust to ‘when it sees continued improvement in the labor market…’  This does not change the intent of the guidance, but it could allow for some take-up from an otherwise disappointing note on lackluster global demand.  Leaving the door open for a policy response this year, the Feds job of readying economic agents in December, if the data warrants, would be easier if the Fed does not overemphasize the implications of still adjusting global conditions.  

Friday, September 11, 2015

FOMC Report September 16-17, 2015; Remove Accommodation or Leave Uncertainty

Remove Accommodation or Leave Uncertainty

In the grand scheme of things the Fed will not cause too many ripples on the cosmic screen of economic life by moving forward with monetary policy normalization at this (September 2015) FOMC meeting or by delaying that move.  The Fed has readied economic agents for the possibility for a policy adjustment at this meeting, but have become more cautious in the face of recent market unrest, a strong dollar and steady but below mandated inflation levels. 

For guide, my analysis suggests a greater likelihood for an October rate hike than for one in September.  Though I would not be as concerned by recent market movements and slow to respond inflation, I suspect enough FOMC members will be disposed to postpone a rate move.       

Many believe that this FOMC meeting is setting up to be the most contentious in years and that Fed members will have a heated debate.  Yet market participants have done little to price the outcome as an even bet.  Instead, Fed Fund futures indicate that roughly a 25-30% chance for 25 basis point target-range shift is priced.

Why Fed Should Raise Rates In September

Possibly the strongest argument for raising the fed funds rate at the September meeting is that it would move the Fed away from an inert state.  Monetary policy at a steady state too long can become stale and allow indecision to creep in.  Monetary policy on hold with as much accommodation provided as is currently the case has brought about a heightened level of market unrest as the consequence of the uncertainty that situation fosters.

Uncertainty about monetary policy direction has likely elevated the market reaction to recognition of a step down in the rate of growth in China.  By moving forward with a policy rate adjustment, the Fed will exit the ‘valley of volatility’ that exists between monetary policy regimes.  We can discuss further the benefits from ‘policy path awareness’ in a bit, but for now we will propose that once the Fed moves from inaction to guarded and modest firming action, a measure of uncertainty as relates to policy intent will be removed and this will likely promote more stable markets.  That stability will engender better economic growth prospects. 

An additional benefit from raising policy rates in September, while there is a less than unanimous expectations for such a move, is that the long end of the Treasury curve might react positively to what would appear to some as an ‘aggressive move’.  If the Fed waits until a rate move is fully priced in the front end of the yield curve, it may make a bullish response from longer-dated Treasuries less likely.  

Grave concerns have been expressed that movement toward normalizing policy rates will bring forth a major correction, along ‘taper tantrum’ lines, in the bond market.  A policy adjustment earlier than a majority suspects would give reason to some to suspect the Fed will need to eventually reverse course and lower policy rates again.  Under this assumption, longer-dated Treasuries yields may move lower, all else equal, and be supportive of growth.

 Why Fed Shouldn’t Raise Rates in September

The most compelling reason for not raising policy rates at the September meeting is that inflation has not shown enough progress toward mandated goals.  While recent oil price weakness and dollar strength may only bring transitory pressure on inflation, the level of confidence held by Fed officials for the return to mandated inflation levels could be much greater.  Additionally, the market turmoil in late-August is recent enough that a negative surprise from the Fed might set off additional market dislocation.  There is too of course, the argument that asymmetric risk attends raising policy rates too early rather than too late.  Finally, as earlier noted, the market has not fully priced a hike and though the Fed has been distancing itself from the notion of ‘transparent’ policy action, they are not yet at a stage where a surprise in policy implementation works to the advantage of policy intent.   

Financial conditions have tightened somewhat since the July FOMC meeting when there was greater confidence that the Fed would hike in September.  Some of the tightening in financial conditions is the result of a stronger trade-weighted dollar value that goes hand in hand with the stronger U.S. domestic economic conditions.  Modest policy rate increase expectations also support a strong dollar contribution to tighter conditions.  Importantly, some tightening in financial conditions is the result of recent weakness and volatility in equity and commodity prices. 

We have long argued that heightened volatility should be expected to accompany the period between monetary policy regimes.  While it is easy enough to understand that economic agents benefit from and take greater risk when they know the Fed is on a determined path to ease financial conditions, it is less clear to some that the same ‘path’ attributes in a restrictive monetary policy directive can be equally beneficial and supportive of risk taking.  Uncertainty in the direction of Fed policy intent is upsetting and has contributed to market volatility.  Less upsetting would be a policy path toward normalization, no matter how minimal its beginnings and no matter how elongated the timing to terminal value.  

Policy Quirk

While the Fed does not want to commit to a strict plan of policy action, it faces continued market volatility.  This volatility reduces risk taking, much of which is constructive given the current modest level of growth.   The Federal Reserve has taken great pains to insure economic agents understand they want to ‘normalize’ policy rates at a very gradual pace within a ‘data dependent’ frame of reference.  That means that while the Fed must always be forward looking, the guidance for adjustments in monetary policy will be the nature and the trend in data. 

Admittedly, an intention to normalize policy in a data dependent fashion with a ‘governor’ of gradualism is a difficult conditional framework to achieve.  It can only really be accomplished if the interpretation of incoming data suggest accommodation be removed at an already prescribed gradual pace. 

There is obvious contradiction to proclaiming a ‘data-dependent’ decision model while ascribing to a gradualism toward normalizing policy.  However, the Fed has awoken to the danger of too much policy transparency in a recovering economy.  A gradual move toward normalized policy implies a policy path while a data dependent guidance means policy choice is purely opportunistic. 

October Rate Hike

Even before the mid-August market volatility, it has been appropriate to consider an alternative to a September policy initiative.  For most economists, that meant either a December response or a 2016 start.  The Fed couldn’t very well say back in March that they were going to be ‘data dependent’, though only allow for the possibility of a policy response every other meeting – at the quarterly meetings that accompanied post-meeting public conferences.  Instead, the Fed needed to indicate that ‘every meeting was live’.  And while there was little reason at that time to be concerned that the data might not stack up nicely to allow for the first rate move to coincide with a quarterly meeting; it is starting to shape up as a distinct possibility the Fed will move at an ‘off-cycle’ meeting. 

There is good debate on how the Fed will proceed at the September meeting.  If the FOMC confab determines that it was a close call for a September move and only a minor difference in the data series would have provided a convincing argument, then we should expect a strong chance for an October FOMC meeting response.  Otherwise, if the Fed indicates at the September meeting that recent market volatility made postponing a rate rise the safe choice, then we might even more make ready for an October response. 

In order for the initial policy response to be expected only as soon as December or later, the Fed would need to indicate that the slack in employment is much greater than they had previously imagined.      


Monday, July 27, 2015

FOMC Report July 28-29, 2015; Transparency Gets Cozy with Data Dependence

There is little reason to think the Fed will surprise with a policy firming at the July FOMC meeting.  Virtually everyone expects they will pass until September at the earliest, though a majority does expect a September start to monetary policy ‘normalization’.  The question being asked is ‘how obvious does the Fed need to be in signaling its first policy rate firming in more than a decade?

It may be enough that a majority currently believes that the Fed will reduce policy accommodation in September.  However, the Fed might want a stronger majority to understand its intention and so thwart any unwanted volatility.      

Data Dependent Does Not Mean Secrecy

The Fed need not collect every last bit of available data prior to meetings before deciding if the timing is right to normalize monetary policy.  Clearly there is a trade-off however between certainty and timeliness; The longer the Fed waits, the more confident they can become that they should (shouldn’t) have normalized earlier.  But that is driving by using the rearview mirror.  They can never know with certainty today that a policy move will prove correct.  What they can do is rely on the progress of data and make assumptions.  In the end, that is all that can be expected.  

Data dependency and transparency are not mutually exclusive.  The Fed can be data dependent and give ample guidance that a policy firming is forthcoming.  The Fed may have already collected enough information to be confident that a policy firming in September is appropriate.  If the Fed is relatively comfortable that enough quality data has been collected in order to decide that a September ‘lift-off’ is appropriate, then they would not gain by making economic agents guess what their intentions were. 

The benefit derived from Fed transparency should out way the cost of taking flack from those who would argue that the Fed had abandoned its ‘data dependent’ promise.  Market participants need not assume the Fed has discarded data dependency as a guide.  The Fed can make clear that it expects data to conform.    

Dana Saporta at Credit Suisse offered a smart way for the Fed to advance its data dependent interests while making a stronger case for the Fed to move in September; "If economic activity unfolds as expected, it may become appropriate to diminish slightly the very high degree of accommodation currently in place.”  Even stronger, the Fed could say “If economic activity unfolds as expected, it ‘would’ become appropriate to diminish…”

In Summary

A large majority already expect the Fed to adjust its main policy rate at the September FOMC meeting.  Unless the Fed has good reason to postpone that move until December (or later), it would benefit from providing additional clarity about its intentions at the conclusion of the July FOMC meeting.  In doing so, the Fed would not be abandoning its stated intention of being data dependent, but would help to facilitate the adjustment with added transparency during this transition period.