Wednesday, January 27, 2016

FOMC Report January 26-27; Leaving Door Open to March Hike



Executive Summary:
There is little reason to expect policy rate action at this meeting.  Though financial conditions have been volatile and economic data has been somewhat softer, job gains continue to surprise on the upside.  Inflation expectations have improved slightly while market based indicators slipped from already low levels. 

The post-meeting statement is likely to refer to economic growth as moderate, but could note slowing in consumer spending and manufacturing.  Dollar strength, foreign economic weakness (China) and global equity market volatility may be noted as areas that deserve continued monitoring. 

Otherwise, the door to a March policy rate move will be left open with risks seen as ‘nearly balanced’, from ‘balanced’ as characterized when the FOMC met in December to first raise rates.  Unity of purpose may limit the possibility for dissent from more hawkish Fed Bank Presidents who might have instead argued for consecutive meeting policy rate moves in the absence of recent market disquiet. 

Going Forward:
There is no reason to pretend no danger exists from recent market volatility and many economists have rightly marked down marginally, current growth prospects for reasons of increased financial stress.  However, we are not inclined to make more of recent dislocation than is prudent.  There are those who argue that the Fed should have anticipated the negative reaction from raising policy rates and that the mistake was obvious given slow global growth and the absence of verified increasing inflation at home. 

If financial markets continue to show signs of stress to the extent that real growth is significantly impacted, the Fed should longer postpone further removal of accommodation.  Otherwise, current monetary policy conditions are still extraordinarily supportive, to the point of providing incentive for malinvestment.   The Fed wants to remove that incentive.  While it is difficult in the midst of financial market turmoil to recognize any benefit therein, to the extent the December policy rate adjustment has prompted economic agents to more thoroughly examine risk tolerance and exposure, it is in the Fed’s interest in helping to provide for sustainable growth. 

Mechanized v. Gradual
As difficult as may be given current attention to disquieted markets, we shall endeavor to put forth a base case for the Fed in the early going of policy normalization as regards the policy rate.  If as suggested above the Fed does not want to continue a policy stance that encourages malinvestment, they will want to move forward with additional policy rate firming while at the same time refraining from making policy moves so predictable that they are emptied of influence. 

The Fed’s challenge, if markets quiet from recent disruptions is to carry forward in removing accommodation guided by longer run equilibrium levels, while giving voice to the value of slowly evolving and over the short run, volatile economic data.  To move policy rates consistently at quarterly FOMC meetings will prove as ineffective as was the efforts in ’04-’06.  Instead, the Fed has to occasionally mix up the pace, if not the level of accommodation removal.  The latter is too harsh a prospect in the early going especially given financial market volatility, so the Fed will be required to provide some variability in the pace of accommodation take up. 

My base case remains for a second quarterly firming in March followed by a pause in that pace by not hiking in June, but following instead with a July meeting move.  By moving in such a fashion, the Fed will have indicated a commitment toward its plans of removing accommodation while it avoids being unnecessarily predictable. 

Leaving the door open to a March policy rate change in communication following the January FOMC meeting, will provide support to financial markets.  It is not the Fed hike in December that has disrupted markets and a Fed overreaction to recent disquiet would only promote additional upset conditions.  It costs nothing to leave that door open and it would cause more problems to have to break that door down if labor markets continue to improve and inflation moves higher in quieting financial markets.  A steady hand is called for by the Fed and they have given such indications over the last weeks.  We should expect they conclude their confab with appropriate concern and the foresight to continue forward with earlier stated intentions to remove accommodation in a gradual and data dependent fashion.    

To stop at one hike upon leaving the zero bound, is to call it a mistake.  To recognize policy action within 6 weeks as being a mistake may be without president.  Instead, even if there is heightened concern as relates to the weakness in China’s economy, the global equity market and energy and commodity prices following the December rate hike, the Fed need not credit those developments to a policy mistake. 

Economic growth still exceeds its assumed longer run potential and employment growth continues to reduce an already diminished human resource slack. 

A pause from additional accommodation removal in March, now largely anticipated and priced, would be a mistake as it would give rise to heightened concern.  Instead, a steady commitment to adjusting the policy rate higher will be seen by economic agents as a welcome constant and consistent with a confidence in the lasting nature of domestic growth. 

Recent equity market weakness and likely some of the reason for lower oil and other commodity prices is the increased acceptance that China is experiencing some difficulty in adjusting their economy from a ‘producer for the world’ status to self-generated or domestically induced internal growth.  Unfortunately there is no cookie cutter guide to redirecting the second largest economy in the world.  Those who would argue that recent developments in China give rise to current financial market disquiet are mistaken.  Instead, it is the awakening of the masses today to conditions that have been developing for years that is driving current risk-off decisions.  Instead of getting worse, China is further along in the bumpy road toward internally generated growth.  The pains of that transition are today as acute for the global economy as they ever will be.           

Finally, we should expect the Fed to remain judiciously aware of recent market disquiet without improperly connecting that activity to their December FOMC meeting decision.  Going forward it is more likely that financial markets quiet and it will be some relief that the Fed had not overreacted.  

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