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.      

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