Tuesday, March 15, 2016

FOMC Report March 15-16, 2016; Enough Growth, But Too Much Volatility



The Fed’s major interest at this point is in achieving financial market stability. Economic agents seem to be more concerned than Fed officials about that prospect. If the Fed can find financial market stability in the short run, it will be more confident in achieving its dual mandates in the longer run.

If stability is lost, so are its longer term goals. After nearly seven years of repair, stability rather than excess is the bigger issue. There have been modest signs of excess in areas like sub-prime auto loans, tighter credit spreads in general and a strong appetite for leveraged loans.  However, the greater disruptive force limiting both economic potential and frustrating the Fed in its desire to ‘normalize’ policy has been the rolling nature of economic performance. 

Market dislocation, having lasted beyond the December FOMC decision to initiate a rise in policy rates, will keep the Fed from raising rates at the March FOMC meeting.  The statement following the meeting along with the message from Chair Yellen in post meeting press conference will indicate a greater confidence in current prospects with recognition of ‘nearly balanced’ conditions.  The Summary of Economic Projections (SEP) will likely indicate an expectation for one less 25 basis point policy rate rise this year in deference to the lengthened financial market volatility earlier this year.  This change will similarly affect later period end points.  However, the longer term equilibrium fed funds target is not expected to fall.    

A cyclical tendency toward economic growth has evolved since 2010 that has allowed expectations for above trend growth seen regularly toward mid-year to be mistakenly extrapolated into forward quarters. As such, while annualized growth exceeds the Fed’s current longer range growth expectations, the volatility in economic growth associated with achieving that outcome creates uncertainty. An uncertainty the Fed does not care for or care to add to.

With annual economic growth at its current pace, but absent the extensive quarterly variance, economic agents would likely be more comfortable with the Fed’s continued movement toward monetary policy normalization, even in the face of divergent other Central Bank activities.

Repeatedly over the last five years, periods of heightened expectations for growth give way to more disparate views of prospects and additional cautious applications of spending and investing.  It is the variability of growth rather than the longer term outcome that distracts and heightens concern which derails both the Fed from normalizing policy and detracts consumers and businesses from spending and investment plans.  Even if growth was marginally slower, but less volatile than seen over the last two years, it is likely economic agents and the Fed itself would be quite comfortable if prevailing policy rates were nearer to 1% at this juncture.

The current backdrop is in line with domestic growth achieving an intermediate-term pace equivalent to or marginally above the Fed’s projected longer run potential while inflation is likely to move at a slightly quicker pace toward its 2% target.  Real GDP (chained ‘09) has grown at a 2.4% YOY pace over the last four quarters and at the same pace over the last two years. Further, the average YOY real GDP growth seen over the last four years is 2.1%. Comparing recent annualized as well as more protracted real growth levels to the current SEP longer run projected 2% potential provides support for a policy rate that is higher than 0.25-0.5% in the absence of vacillating performance.

The degree to which economic agents have been affected by the unsteady nature of economic progress is demonstrated in the enclosed chart of the Citibank Economic Surprise Index – United States (Source: Bloomberg LP). Here a cyclical tendency in the flow of economic data is quite evident. It is apparent that stronger economic growth in mid-year is extrapolated, but not achieved. Softer late-year growth too is over-emphasized and the data series once again outperforms expectations, setting up an annual recurrence. We appear to again be at the point where weak late-year growth is found not to have been as lasting as earlier feared.

Note also the rather modest swing in the Economic Surprise Index since early 2015 relative to that seen in prior years.  It could be that economic agents are simply becoming less surprised in the cyclical nature of economic data.  In any case, a reduction in over-reaction could help to bring in line the data itself on a path more conducive to the Fed ‘normalizing’ policy rates.