Monday, October 31, 2016

FOMC Report November 1-2, 2016; "Alright, OK, Make a Path"



Executive Summary: 

The Fed is again not expected to raise policy rates at this FOMC meeting.  We place the odds of a rate hike at 7% and the hike probability is this high largely because there were 3 dissenters at the September meeting (Esther George, Loretta Mester, and Eric Rosengren), otherwise the odds assumed would be even lower.  A stronger case for a November FOMC rate hike could have once been made if housing and production data had been stronger.  Even under such conditions however, there would still have been concern about the implications of a policy move immediately in front of a Presidential election.  Unless economic data had been overwhelmingly strong, economic agents would have found it difficult to price a policy move.  Assuming Fed officials had such a desire to ready market participants for a November rate hike, they would have needed a lot more ammunition than was made available in the economic and financial data since the last meeting.  We might again expect the statement to show a stronger collective interest in moving forward with a rate response at an upcoming meeting.  In this, economic agents will read upcoming as meaning the December meeting.  With the market already pricing greater than a 70% chance for a December hike, the post-Meeting FOMC statement need not be any more specific about their intent.  

“Alright, OK, Make a Path”

Never before has such an overwhelming amount of data or such extraordinary analytic capacities been available to those who study the economy, financial markets and monetary policy.  To this end, a growing majority has come to expect the Federal Reserve will provide a pace of accommodation removal that in golf parlance might be described as a ‘worm-burner’ (a shot which barely rises above ground level).  Those with great recall capacities will remember that the Fed did indeed remove a modicum of accommodation at its last yearend meeting.  If the Fed carries forward with policy prescription widely expected, then a second consecutive yearend modest removal of accommodation is forthcoming. 

Long a fan of policy paths, or more exactly, extremely fond of coming to terms with path implications prior to their being accepted as paths by a strong minority1, we cannot help but expect that the outcome from the December 2016 FOMC meeting shall prompt many to drawn a line from December 2015 and through 2016 December.  This line, with modest beginnings at 12.5 basis points finds reference marks at both 37.5 basis points (mid-point of current policy target range) and if a large majority view is correct in anticipating a Fed policy response at the December FOMC meeting, then an intersection again at 62.5 basis points is expected.  A cleaner line cannot be drawn.  There is no curvature offered and it shall be expected to strike both 2017 December and the year following December at 87.5 bps and 112.5 bps respectively. 

Old dogs and young pups search again a spot where success was found in the past.  Apart from their studies, the financial market equivalents of young pups have experience concentrated in policy rate data points hovering at or about the zero bound.  Old dogs, having long ago found meat at higher policy rate grounds have struggled to pick up the scent at these lower policy rate grounds.  Old and young and all breeds irrespective will be drawn toward the policy path described by 25 basis points at each December FOMC meeting.  Whether conscious or otherwise, decisions will be swayed by this simple policy path projection. 

There shall be such a force directing expectations for a third and fourth point falling on the policy path line that evidence arguing against will need to be overwhelming before it will sway a majority of economic agents.  As such, advanced knowledge or understanding that data is or will continue to argue for a stronger (or easier) policy response will not at first be an advantage if one acts in accordance too early.  Instead, expecting strong resistance against pricing a steeper (or less steep) policy trajectory will benefit the patient position taker. 

It is probably worth remembering a bit of recent history surrounding yearend December FOMC meetings.  At the December 2013 FOMC meeting, the Fed answered the question that was of concern since mid-year.  The trial balloon that Fed Chairman Ben Bernanke tried to float concerning the lasting nature of the securities purchase program blew up in his face because he failed to attach to that inevitability a policy path.  That trial balloon resulted in what became referred to as the ‘taper tantrum’ and it would not have happened had the Fed done in mid-2013 what it eventually got around to doing at the yearend December 2013 FOMC meeting, providing a policy path for tapering securities purchases.       

It was not the proposed reduction of securities purchases that spooked the market.  Rather, it was the not knowing any particulars of such a reduction that economic agents found mortifying.  Frankly, they hung to assurances offered in the modest amount of transparency provided by policy path described by the purchase program regularity, like the drowning to a flotation device.  When Bernanke took those assurances (the policy path of securities purchases) away, the market reaction was similar to that of someone drowning.  

Had Bernanke in mid-2013 simply substituted the policy path of the purchase program with a policy path for tapering the purchase program, as was eventually done, but little expected at the December 2013 FOMC meeting, there would likely never have been the famous ‘taper tantrum. 

Another standout December policy action took place at the December 2008 FOMC meeting where the policy rate was reduced by 75 basis points and where a target range (0-25 basis points) was first introduced.  That policy rate of course held until last December 2015 when the target range was increased by 25 basis points to 25-50. 

The Fed has an opportunity to add the market calming effect of policy path if it raises policy rates at the December meeting.  By doing so, the already low market implied volatility should be expected to stay well offered for some time until a strong challenge can be made against the status quo of annual minuscule policy rate adjustments. 

1)    The Fed and Interest Rates: ‘A Pause in August means a Pause in September’ FOMC Report - August 8, 2006

For quite some time my basis for Fed projections has been that the visibility provided by the Feds transparency in the prior period of ‘path-dependent’ policy directive was sufficient to prompt higher levels of risk assumption than would normally have been the case in a less predictable, restrictive policy directive. The removal of visibility resulting from the recent change to a ‘data-dependent’ policy directive (irrespective of any level of transparency) should prompt some unwind of excessive risk exposure that was enjoyed during the period of greater visibility.

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