Tuesday, December 15, 2015

FOMC Report December 15-16, 2015; Onward Toward ...ahem, 'Normalization'

 Onward Toward ...ahem, 'Normalization'

Executive Summary: 

Expect the Fed to raise policy rates by 25 bps, where the fed funds are likely to continue to trade between the corridor of interest paid on excess reserves (IOER) on the upside (50 bps) and the overnight reverse repurchase rate (RRP) below (25 bps).  We should expect no effort spared in conveying the message that future policy initiatives will be directed by incoming data.  At the same time, it will also be stressed that only a modest and gradual policy response will likely be required in the face of continued attainment of dual mandate goals projected.  Transparency continues to play a role in policy communication and I was surprised by the comment made by Chair Yellen at her December 2 outing concerning the importance of the ‘dot plot’.  We should probably expect that the longer run equilibrium rate will be reduced and highlighting that likely change will somewhat direct attention away from the fact that policy rates have been risen for the first time in a decade. 

Guidance During Normalization:  

Fed transparency can take many forms.  I have long argued that in nearly all cases however, Fed transparency works as an agent for only one side of the Fed’s dual mandate.  In nearly every instance I can imagine, Fed guidance acts as a support to growth.  Even in instances where guidance is directed toward advising of tighter forthcoming monetary conditions or policies, economic agents benefit from some removal of uncertainty. 

Transparency by the Fed has received a bad name of late and in nearly all official communications over the last three months, a ‘data dependent’ conditional reference toward monetary policy intent was explicitly stated.  In all fairness, the Fed has always operated under a ‘data dependant’ frame of reference.  Though in reality, that data dependency was at times pushed to a back burner and somewhat out of sight. 

Clearly the Fed wants to avoid a recurrence of the malinvestment it helped wrought when it engineered, between 2004-2006, a grave monetary policy blunder by advancing to economic agents a specific roadmap to policy intent that extended well beyond their view of the economic horizon.  It is very unlikely we will anytime soon see this mistake repeated.  At the same time, the Fed should be careful not to discard a valuable monetary policy tool just because it was once misused. 

I would argue that it is not time to jettison communicational support in the form of policy guidance just yet.  Clearly if and when the economy gains traction, say in the form of successive quarterly real domestic growth figures in excess of 2.1%, the Fed could throttle back on communications support and let a decline in pampered communication act to increase the level of vigilance on the part of risk-taking enterprise. 

One of the most interesting attempts at expectations management we have seen in quite a while happened only weeks ago when Fed Chair Yellen answered a question following her December 2nd appearance in front of the Economic Club of Washington when she discussed ‘The Economic Outlook and Monetary Policy  monetary policy.  In attending to the prospects for forthcoming policy initiatives, she extolled the virtues of the ‘dot plot’ (outlook for policy rates over next three successive years and the longer-run equilibrium level described in the quarterly Summary of Economic Projections (SEP)) for anyone looking to better understand the likely path for policy rates as being only gradually and modestly higher. 

You may remember, as I do, when Fed Chair Yellen earlier this year cautioning against reading too much into the ‘dot plot’ and that the Statement released following the FOMC meeting was intended to provide any needed information concerning policy intent going forward.  There must be a reason Chair Yellen drew attention to the ‘dot plot’ in front of this meeting. 

Fast forward to the upcoming FOMC statement, the SEP and the post-FOMC meeting press conference; We should expect that the December SEP ‘dot plot’ indicates a lower trajectory for the policy path than described in the earlier released September FOMC update and the longer run equilibrium level of fed funds too is expected to be lower than earlier projected.  Specifically, we might expect an eighth to a quarter point removed from each of the year end projections and a quarter point removed from the longer run equilibrium fed funds rate from 3.5% to 3.25%.  Some Fed watchers expect the Fed may even lower the longer-run equilibrium rate toward 3%. 

I caution against misinterpreting the meaning of SEP values and that they are intended to demonstrate each individual member’s expected values based on monetary policy being conducted in a manner they themselves believe most appropriate.  Clearly we cannot imagine that each individual within the FOMC has similar views on the appropriate course of monetary policy and thus, a collection of their individual expectations does not lead to an extremely robust or meaningful value.  However, it is better than nothing.

Should the Fed decide to raise the policy rate at the December 2015 FOMC meeting, as I expect and as is widely expected by a majority of Fed watchers and economists, then this forthcoming SEP report could be the last chance for participants to lower their expectations for the longer run equilibrium rate.  After the first instance of policy rate normalization, it makes less sense to continue to reduce the longer run equilibrium rate.  If that longer run rate has not stabilized by then, the Fed would more likely refrain from further rate hikes and review their assumptions to see what has changed that they had not earlier anticipated.  

Lowering the longer run equilibrium again, something widely expected, could ‘soften’ the impact from a shift in policy from accommodative toward neutral.  In the absence of a decline in the projection of the longer run equilibrium rate however, even if the projection for forthcoming year end(s) rates are lowered, sellers might become aggressive in back month Eurodollar futures and intermediate term treasuries. 

In Monitoring Normalization Progress:

We shall want to keep close watch on the ‘take up’ of any policy shift.  In that I mean we will want to take note of how much effort the Federal Reserve Bank of New York (FRBNY) Market Desk needs to exert in order to guide fed funds toward the middle of the policy corridor.  The easier it is for the Fed to direct policy rates higher, given the extraordinary level of excess reserves, the less incentive the Fed will have to jettison its bloated Federal Reserve System Open Market Account (SOMA) portfolio of securities.  The longer the timeframe expected for the Fed to hold those securities, all else equal, the greater the effort required of the policy rate in removing unneeded or unwanted levels of accommodation. 

Another topic I would like to touch on is ‘term premium’.  Currently the term premium for 10 year Treasury notes is near zero, coming from -0.41% in January. 1 The Fed will be watching the term premium rather closely with concern that long end rates might jump higher on the back of elevating term premium.  One of the areas believed to be helping to hold down term premium is the low level of projected inflation which may be bleeding over into the term premium calculations.  Additionally, lower European long rates are believed to have some cross border effect on term premium here. 

During the period 2004-2006, concurrent with exaggerated monetary policy forward guidance provided during the ‘restrictive policy’ initiative, term premium collapsed.  So while the Fed is concerned that rising term premium might signal a potential jump in long rates, they are also concerned that a term premium that remains too low could be signaling that economic agents are too confident that the Fed is on a pre-determined policy path.  Of course, the implication for this is exaggerated risk taking in the face of still higher policy rates. 

We are entering a most exciting time of monetary policy development.  Even if it were not for the divergence in policy activities between other G7 nations, the challenges facing the Fed in proscribing the appropriate monetary policy going forward is great.  They have to adopt to a lower trajectory for economic growth while recovering from a placid inflationary environment.  They are burdened by the baggage of policy errors in the mid-2000’s that they need to overcome.  Finally, they will want to plot a reasonable course that allows them to shed a sizeable SOMA balance sheet. 

As we move from a period of accommodation to a neutral policy stance, there will be continued volatility and overreaction to economic and monetary policy developments.  Importantly, there will be clues along the way that will help guide not only appropriate monetary policy, but also for us to understand likely changes in interest rates across the curve, growing or diminishing credit concerns and directionality on a number of asset classes. 

Finally, we will be allowed to cross the street without the Fed holding our hand; Just keep a keen eye on traffic.       

1.   Yellen’s Focus on Term Premium Getting Noticed in Bond Market

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