Tuesday, September 20, 2016

FOMC Report September 20-21, 2016; Monetary Policy in the Awkward Middle

Executive Summary: 

The Fed is not expected to raise policy rates at this FOMC meeting.  The odds of such a rate hike are at 10% by my estimate and remain this high because of the particularly disjointed message received from Fed officials since their meeting in July.  A stronger case could be made for a policy response at this meeting, but such a unified message was not articulated by Fed officials.   Economic prospects rather than overwhelming evidence from current conditions are not believed sufficient to carry a decision to raise policy rates at this meeting.  Instead, a stronger message in the statement and post meeting press conference will be the concession to the more hawkish Fed contingent.       


Monetary Policy in the Awkward Middle

Federal Reserve monetary policy has returned to the ‘no man’s land’ between easier and firmer monetary policy regimes.  Despite ever increased central bank communications and continued efforts in increasing transparency, the Fed appears increasingly less able to impose an imprint even on policy actions, much less economic activity.  Fed talk of firmer policy initiatives down the road gets pushed to the shoulder as each initiating point comes more clearly into view. 

At this stage, the initial December 2015 rate hike is so far in the rearview mirror that to suggest that a next rate response is connected would be a stretch.  The notion of ‘gradually’ returning to a more normal policy stance while being governed by a ‘data dependent’ yardstick has offered communication challenges from the start.  While the former implies some regularity, the latter is both suggestive of a rule-based approach and at the same time left to interpretive influences.  The Fed has tried to straddle the line between providing guidance and allowing expectations for their policy initiative to be interpreted by reading into the flow of economic and financial data.  This would of course be made easier if everyone was in agreement as to what the Fed’s reaction function is or should be.   Interpreting monetary policy from economic and financial market data is made all the more difficult because is no universally recognized Fed reaction function.

For now it is important to recognize that policy mistakes made in the middle ground between an easy and a restrictive policy regime carry greater weight.  While both sides of the policy regime coin offer the market stabilizing influence from a known, implied, envisioned or imagined ‘policy path’, that stability of policy path is absent as the coin stands on its side between heads and tails (accommodative and restrictive). 

When the Fed is widely understood to be carrying out a restrictive monetary policy initiative, some adjustment should be expected as data comes to light that does not jibe with market expectations for already priced pace for the removal of accommodation.  Similar conditions exist for easier monetary policy regimes.  However, market adjustments made when neither policy regime is in place tend to be of greater magnitude because economic agents have less confidence in their ability to interpret the monetary policy response to changes in current conditions.  The lack of a monetary ‘policy path’ leaves absent the potential for modest scaling to or from those prior expectations.  Instead, in the monetary policy middle ground, each modest outlier from expected data requires a reformulation of policy expectations and thus greater market volatility.     

As such, when the Fed finds itself between policy regimes and without a more firmly recognized policy path, it is all the more likely to delay a policy response that is not more widely expected by economic agents.  This is true at an extreme where policy rates had earlier been driven higher and have peeked before coming lower, but is even more important to understand this when policy rates rest nearer to the zero bound. 

We should therefore not expect the Fed to firm policy rates at this September FOMC meeting.  The risk for surprising economic agents does not appear likely to be offset by any sizeable benefit from raising rates.  Therefore, it is more likely that more hawkish Fed officials will position for is a stronger statement and more upbeat assessment in the post meeting press conference.


Summary of Economic Projections

The Summary of Economic Projections (SEP), is expected to show a majority of Fed officials are looking for one ‘additional’ rate hike this year.  Even though there has been a strong voice within for the Fed to firm policy rates, the continued discussion of low and falling equilibrium level of interest rates (r*) suggests that the path for policy rates implied by the ‘dot plot’ will be reduced through 2017-2018.  In line with gradual reductions in forward expectations in the past, it is likely that the median estimates for 2017-2018 and even longer run will be reduced by roughly 25 bps.  It is not as clear that the longer run fed funds rate will be lowered at this meeting.  This may be a concession that the Fed doves can give in order to placate the officials with more hawkish desires.  GDP growth for 2016 will likely be scaled back further (1.7-1.8% from 2% June) because of a slower than expected Q3.  The balance of the SEP is not expected to see great change.    


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