Tuesday, June 17, 2014

FOMC Report June 17-18, 2014

Expectation: The June FOMC statement will remain largely unchanged from April though it will acknowledge slightly improved current growth prospects.  The ‘policy-path’ of tapering will continue with another $10 billion cut.  Work will continue but no firm exit strategy will be announced until the July FOMC meeting.  In the SEP, 2014 yearly growth expectations will be lowered. In an effort to learn more than the Fed is willing and able to divulge now, a reporter may move beyond the line of respectful inquiry.  Chair Yellen will be unfazed and will reiterate earlier offered guidance.  This is not a meeting that will shake things up.    

Two separate topics that currently rate high on the ‘go-to’ reading lists of market savvy are low volatility and Fed exit strategy.  Questions surround both and while proper questioning often produces useful answers, the transition from unknown to known, for the purposes of our discussion here, often involves strong market movement. 

Low volatility and decreased trading activity are evidenced across the spectrum of asset classes from bonds to stocks and from commodities to metals.  Low volatility along with unanswered questions is not really a steady state and we can expect that either low volatility will not persist or the answers found will have already been largely discounted. 

It has been years since the Fed last outlined an exit strategy from extraordinary accommodation.  It’s time for a revamp now, especially as consensus forecast places the policy rate lift-off date about a year away.  This of course is not to say that the policy rate, whether that is the heretofore standard fed funds or a newer possibility IOER or ON RRP, will be used in the first step in the transition from extraordinary accommodation to ‘normal’.   Another possible first step (or next step if you argue that tapering was the first step) would be for a quitting of the reinvestment of principal and interest in the SOMA portfolio.   In any event, we might expect this quandary being wrestled out in the market place would engender higher levels of volatility.  Policy maker’s comments should provide leverage to one side or the other in the argument thus creating more trade and greater volatility.  This has not been the case.   

One reason for lower volatility may simply be that there has been fewer Federal Reserve Board Governors’ with correspondingly fewer public comments.  The argument being that fewer conflicting comments invite a steadier market.  It is doubtful however that fewer Fed Governors’ are reason enough for punk trade and low volatility.  Greater weight might be afforded comments from fewer Governors’ instead of those messages being diluted by a fuller compliment of the Board. 

There is widespread expectation for the Fed Summary of Economic Projections (SEP) to show a still lower forecast for 2014 real GDP from the 2.8-3.0% projected in March.  Less certain but possible is a further lowering of the longer-run ‘equilibrium’ growth rate projection which, as written about in my March FOMC Report, has steadily declined since November 2011 from 2.5-2.7% central tendency to 2.2-2.3% in March. 

There is room for some disparity between the message as appears in the context of the FOMC statement and the apparent message from the dots in the SEP.  Stronger language in the FOMC statement related to brighter growth prospects and inflation that is coming more in line with Fed target may seem at odds with the continued low and possibly even lower marks for longer-run growth and equilibrium policy rates. 

Lower long-term growth expectations help to keep Treasury bond yields low but they can also have an impact on expectations for immediate prospect.  Where recoveries from recessionary periods generally experience growth above the longer-term trend, present expectation for depressed longer-run growth potential has a risk of stifling current growth.  Already, growth since recession end in June ’09 has only averaged 2.1%.   

If the Fed had a desire to mislead the public in an effort to bring long-rates lower, there is scarcely a better approach than to adjust lower public expectations for longer-run growth.  The Fed has helped reduce expectations for longer run growth by consistently missing their more optimistic nearer-period forecasts for growth over the last 4 years and by steadily lowering the SEP longer-run forecast over the last 2.5 years.  Endearing though arguably indicating ineptitude, neither the repeated annual growth forecast overshoot or the steady decline in long-run base growth potential forecast have been faked.

Chair Yellen shares an interest in painting a picture of longer-run prospects as accurately as possible as indicated in her stated and practiced principle.  However, she is also willing to act as a cheerleader as shown in efforts toward incorporating a wider interpretation of unemployment.  As such, she might want to tweak the FOMC statement description of current or immediate economic prospects slightly elevated relative to economists’ consensus in part as an effort to thwart a negative pull from a reduced longer-run GDP forecast in SEP. 


Those who would assume that current low levels of volatility are simply attributable to dangerous levels of complacency may be missing an important consideration.  Central Banks have had a strong impact on the current level of volatility and this situation should be expected to persist for some time.  Economic agents have come to expect central bank intervention, transparency and guidance.  In general the message from central banks, the Fed in particular, has been that rates should be expected to remain low for some time.  The Fed has implied that even if economic conditions do not necessarily seem (by historic standards) to justify low policy rates, longer standing headwinds may warrant low policy rates to persist for a time.   

A greater influence on volatility than a message for persistent low rates is a belief that a decent chunk of the central bank policy rate timeline is knowable.  Different levels of confidence about the likely path for policy rates attend different periods of policy transition.  Historically, a transition from a neutral policy stance to a restrictive one would be expected to draw the greatest level of policy uncertainty.  More recently, this transition has been smoothed.  Incremental changes in policy have become the norm and concerns are much lower for more abrupt or hurried tightening.  Until the Fed gets a better handle on how to communicate during a restrictive (or removal of accommodation) policy initiative, the greatest risk for unwanted volatility will come toward the end of a tightening regime or when the Fed finishes raising rates.     

A low level of confidence for the Feds ability to determine the appropriate path for rates accompanied the height of the financial crisis.  While it was expected the Fed would react aggressively and bring policy rates lower, it was not apparent at the time either inside or outside of the Fed just how low rates might need to go and for how long would they need to stay there in order to arrest the deteriorating condition.  During such times, volatility and term premium remain high.  Later, after the recession ebbed and the extent of the damage appeared measurable, a greater confidence emerged in an ability to predict a longer period of the Fed policy rate timeline.  That greater confidence was followed by generally lower levels of volatility and term premium.   

However, we would be wrong to assume that lower levels of volatility and pressured term premiums necessarily coincide with low or declining policy rates.  Low volatility and term premium most certainly can come about during periods of rising policy rates.  Consider the period mid-’04 to mid-’06 when the Fed was struggling at lower levels along the communication learning curve.  At that time the Fed moved policy rates gradually higher in an entirely predictable fashion.  The VIX and MOVE indexes fell steadily during that period as economic agents seized upon the risk-friendly characteristics of the known policy-path.  Conversely, as the Fed lowered policy rates between ‘01 and ‘03, these indexes generally rose as economic agents were less confident that a lengthy policy-path for rates could be discerned.  

Again, possibly the biggest reason for increasing volatility in the Fed ‘easing’ period of ’01-’03 and the decreasing volatility in the ‘tightening’ period of ’04-’06 was due to the level of confidence economic agents had in their understanding of the Fed policy rate path.  In the ’04-’06 period economic agents reached great levels of confidence that the path for rates was known.  Confidence in a longer chunk of policy timeline, when policy initiative is an influential determinant of growth can clearly weigh on volatility and term premium.    

Currently economic agents have a high level of confidence that policy rates stretching far out the timeline are known.  As much as guidance from the Fed has helped to support this conviction, the economic and inflationary backdrop is also consistent with only modest improvement over the coming year almost irrespective of what the Fed might do.  Even though the Fed may move forward or backward slightly the expected timing of the policy rate lift-off there is still confidence that a post-lift-off glide path will be rather shallow.  It is not low rates or even the path for rates that impacts volatility as much as it is the expectation for variability about the path.  The Fed is expected to follow a well articulated script in the transition from aggressively accommodative to lesser levels of accommodation.  By providing believable likely future values for policy rates as well as the disposition of the SOMA portfolio, the Fed will for a time help to keep volatility low. 

However, and this is where I expect some to have difficulty following, if the Fed provides enough visibility in the form of usable transparency then volatility and term premiums should be expected to remain low and the appetite for taking risk will grow even as the Fed raises policy rates. 

The Fed may have shown some movement up the communication learning curve in the most recent policy shift toward tapering.   The Fed has learned to provide useful transparency in the form of a ‘policy-path’ description for the process of tapering of securities purchases.  Prior to the discrete and regular reduction in purchase amounts clearly articulated in the December FOMC statement and followed-up in action since, there was some heightened uncertainty concerning the process by which the Fed would step away from that form of accommodation.  By providing useful transparency in the form of measurable changes to expect in asset purchases and portfolio holdings through stages and time, the Fed helped to lower market volatility which in turn pressured term premiums and nominal rates lower.  The unknown Mr. Bernanke had awakened in the ‘taper-tantrum’ of mid-’13 had become a known policy-path, lending visibility and economic support despite lower levels of actual QE accommodation.

The Fed has become increasingly aware of the importance of communication and more adapt at affecting economic agent activities through the use of guidance.    It should be expected that the Fed’s application of guidance will be generous and widely encompassing in its use in tandem with each of its policy tools in the period of transition from greater to lesser levels of accommodation.  This has clearly been the case already with the tapering program.

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