Wednesday, June 15, 2016

FOMC Report June 14-15, 2016; Gradual is as Gradual Does

The gradual pace for ‘normalizing’ monetary policy Fed officials have since December indicated as appropriate is only one meeting away from becoming a dated concept and unsuitable.  As relates to monetary policy, gradualism implies at least some movement.  For most, a pace recognized as gradual would include some policy movement at a minimum roughly semi-annually.  Therefore, a next-move in policy rates further afield than July would not really be suitably termed gradual. 

A policy move later than July, if connected at all to the December initial policy rate hike suggests the pace of normalization be more appropriately termed ‘sluggish’ or ‘unhurried’, if not ‘ad hoc’.  The time lapse between policy rate moves at this juncture is no small matter and is not easily dismissed. 

It has been a long time since economic agents were afforded any meaningful guidance from the Fed which might reduce uncertainty surrounding monetary policy.  Not since the Fed finished tapering securities purchases have economic agents had helpful visibility[1] (McGuire, 2016) from Fed transparency.  Mindful of their inability to provide significant visibility, the Fed has said that the unfolding of economic data (data-dependent) would guide Fed officials in determining the appropriate timing of policy normalization moves.  Now however, the Fed is indicating the very nature of the economic data gathered brings into question their ability to determine the correct policy response.      

Fed Chair Yellen appeared to make every effort possible in her June 6th speech ‘Current Conditions and the Outlook for the U.S. Economy’ delivered at The World Affairs Council of Philadelphia to convey a message of doubt.  She noted; ‘In particular, an important theme of my remarks today will be the inevitable uncertainty surrounding the outlook for the economy.’  Indeed, she offered just that.  Chair Yellen did describe current conditions, but she did so in relation to a discussion on uncertainty.  She used the term uncertain no less than 15 times in here remarks.   So conveyed was the notion that there can be no monetary policy guidance at this stage that it is surprising that financial markets did not react more violently.

It is widely understood that a good accounting for the effectiveness of Fed transparency is gauged by the amount of market volatility immediately following the post-FOMC meeting communication.  If the Fed is able to provide a good sense for the conduct of monetary policy and thus likely outcome of the FOMC deliberations, asset prices should be fairly adjusted to a post-meeting message.  It is argued such transparency leaves little room for asset price volatility thereafter.  Fed Chair Yellen made clear in her recent speech that even if there was a willingness to provide such guidance, it was simply beyond the capacity of the Fed to offer any direction in monetary policy prospects given current conditions.       

Because of the Feds difficulties parsing current economic conditions, it is realistic to expect some change in the dynamics between the meeting statement and market response from this and possibly future FOMC meeting deliberations.  Under circumstances less desperately described as Chair Yellen noted in her June 6th speech, market participants could be rather confident that post-meting volatility would be checked or tempered by the likeness of the statement message to the pre-meeting conditioning.  At the June meeting however, meeting participants (as well as economic agents at large) may have quite dissimilar views, sculpted in large part by more recent economic data which could prompt a message and policy direction quite alien from what the market has currently priced.  

In any event, it is quite conceivable that economic agents are prone to respond more aggressively to any post-meeting message than at any time in recent past.  Chair Yellen indicated the highly unpredictable unfolding of economic conditions with implications for similar uncertainty as regards monetary policy.  Under such circumstances, the reaction to post-FOMC meeting communication could be considerably more volatile than what has been the longer run norm. 

There are two primary reasons for a greater chance for market volatility following the FOMC meeting.  First and most obviously, the Fed may leave more unsettled the chance for a policy response in July.  Secondly, it may more largely distance itself from the prospects of a July rate response.  In the first instance, reduced visibility would lead to greater volatility.  More importantly perhaps, in the latter, the creditability of the Fed’s long held commitment to a gradual pace for monetary policy ‘normalization’ is threatened.  As such, the Fed has ample reason to indicate at a minimum that the July meeting is still ‘live’, if not a likelihood for a policy response.   

Had the initiation of ‘normalization’ been delayed, possibly from December to March, the notion of gradual might still apply.  However, should the Fed be required to postpone the next rate response beyond July, the very idea that policy normalization is progressing would be at stake.  Even as the Fed has made perfectly clear that data dependence is at the forefront of policy deliberations, gradualism supposes that the unfolding of that economic data will allow for policy movement.  Otherwise, it simply would not be fit for the Fed to qualify its course of action as gradual. 

It is the nature of that data unfolding which is expected to provide reason for a gradual pace for policy normalization.  Economic agents might rightly differ as to their understanding of the limits to the delay between policy moves which could still be considered as gradual.  However, if policy response is not seen in a timely enough manner to qualify largely as gradual, then it must be assumed that there is really no ‘path’ (gradual or otherwise) for policy rates and the Fed is operating in ad hoc fashion.

The implications for financial market stability are not small when considering operation under ‘gradual’ verses an ‘ad hoc’ frame of reference.  Gradual implies a policy path, which though not strongly defined allows some capacity for predictability.  This policy path aspect or implication of gradualism in terms of monetary policy application invites stability as it lends visibility through Fed transparency.  Monetary policy operated under an ad hoc framework simply cannot provide any such policy path framework and would therefore more generally lend itself to promoting rather than reducing volatility.    

Further, a gradual pace for monetary policy action implies some ability to model such a framework.  That is gradualism implies some regularity or degree of predictability which can be used in model building.  Whether that predictability is fitted into multi-variable econometric models or simply assimilated into the projections of average consumers, a change to a less predictable state can have dramatic repercussions.  They will likely reduce both the value of the output from econometric models and would of course reduce the willingness of consumers to spend and businesses to invest. 

Models built upon projections for monetary policy are often more robust when they are kept uncomplicated.  Right now, many models using policy projections presume a slightly less than gradual pace for policy firming.  This is evidenced in the pricing of interest rate derivatives (futures and options) that assume rate firming of less than 50 bps per year over the intermediate term of 1.5 years.  These models are stretched to their limit in their ability to provide meaningful output.  It is difficult for these models to recognize as a continuous policy regime, policy action that is separated by more than six months.  Using recognized economic projection techniques, there is little room beyond current conditions to provide meaningful model output from even less timely policy responses.  They simply become too distant from one another to be considered consistent with one policy regime and instead become ad hoc or distinct. 

While there has been more than a few who suggested the December rate hike would be the only such removal of accommodation (‘one and done’), the Fed has clearly not given up on the notion that further accommodation removal will be appropriate.  In order for financial conditions to remain calm following the June FOMC meeting statement, the Fed will need to give some assurances that the data has been sufficient to warrant strong consideration for July as a next-response meeting.  Otherwise, the notion of gradual policy unfolding is lost and Fed guidance, largely absent for nearly two years is completely missing.  Without stronger economic performance, a rudderless monetary policy might be too difficult a burden for economic agents to bear and a wide scale reduction in risk appetite could ensue. 

We are therefore very cautious on the approach of the June FOMC meeting and while we suspect the Fed will provide assurances that they are still operating similarly and that July is a ‘live’ meeting, unless they can make such an argument believable, a strong ‘risk-off’ preference could prevail. 

[1] [i][i] ‘Visibility’ (The ability to see or be seen; the quality or state of being known to the public) as regards monetary policy is very much different from ‘transparency’ (Transparent-able to be seen through; honest and open: not secretive) in that visibility is something that can be seen whereas transparency only speaks of the lens by which reality is viewed.  Think of a windshield as providing transparency for a driver.  A clean windshield allows the driver to see clearly the road ahead.  A muddied or rain splattered windshield would limit the transparency of the window regardless of the situation ahead.  Visibility is the extent the drivers view is unobstructed beyond the windshield.  If he is on a long, straight and open road, his visibility is high.  If he is on a crowded and highly curved mountainous road, his visibility is limited. 
The Fed can more easily keep the windshield clean (muddied) as it prefers in providing information (keeping information secret) to the public than it can produce ‘visibility’.  It offers visibility when it provides believable assurances as to when and how it will adjust its monetary policy.  Currently, the Fed does not have a level of confidence in economic and financial market projections to provide much visibility outside of indicating that it does not intend to end reinvestment of interest and principal for its securities holding until policy rate normalization is well underway. 

Can you imagine any ‘policy paths’ the Fed might create that would provide additional ‘visibility’ that either do not currently exist or have been overlooked as a source for increased financial market stability?  Did you realize that the reduction of latest purchase program in incremental format was an engineered ‘visibility’-add.  Intended or not, this addition of visibility provided greater understanding to policy intent which attracted higher levels of risk assumption than would have been the case in its absence.  Note that when then-Fed Chair Ben Bernanke had in mid-2013 discussed removing or reducing the purchase program without providing a ‘policy path’ for that outcome, the market responded violently to a loss of ‘visibility’ in the purchase program that existed.  It was not until the ‘policy path’ for purchase tapering was unveiled that economic agents again had a renewed sense of policy awareness.  This of course contributed to greater economic growth than available in its absence. 

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