Monday, January 30, 2017

FOMC Report Jan 31/Feb 1, 2017; A Veiled March Door Open?



Executive Summary: 

The FOMC statement is expected to read modestly upbeat with regard to economic prospects without offering any great assurance that a policy move should be expected as soon as the March 2017 FOMC meeting .  Still, we view the risk for language adjustment in the FOMC statement as leaning toward a stronger or more hawkish message than is widely expected.  While the impact of changed US Executive Branch policies remains uncertain, prevailing trends over the last months may be sufficiently positive in their own right to warrant modestly accelerated accommodation removal.  Finally, should the Committee wish to open the door to a March policy response, it is more likely to provide that clue in its discussion on inflation rather than growth or reduced global concerns. 
  
Current Conditions

Recently released Q4 GDP data showed less robust than expected at 1.9%, given a meaningful subtraction from net exports (-1.7% ) – the greatest shortfall since 2010.  This still leaves H2 2016 GDP at greater than 2.7% and robust in comparison to that seen over the last years. 

Year over year Core PCE, the fed’s favored inflation gauge, increased at 1.7% in the latest December reference.  This latest read is above the November and 12 month moving average and not terribly far from a dual mandate goal of 2%.  

Recent gains in equities along with modest recovery in Treasury Securities prices since mid-December have benefited financial conditions and have given support to increased economic activity.  Measures of market implied volatility have been low, indicating some level of confidence.  The VIX Index recently traded to its lowest reading since mid-2014.  The Merrill Lynch Move Index, a measure of Treasury security implied volatility is below the 50 day moving average and nearer to the low seen since early November.           

 
Some Sense of Urgency       

Economists are abuzz discussing and interpreting the implications for an earlier introduction of the normalization of the Feds balance sheet.  The FOMC statement due Wednesday afternoon is not expected to offer any additional evidence that the Committee is strongly considering moving forward its intended implementation timing for stopping or curtailing regular reinvestment. 

A majority of FOMC Committee members are expected to favor additional normalization of the fed funds policy rate before any movement toward balance sheet adjustments are made.  Currently the Feds stance is that balance sheet adjustments would not commence until policy rate normalization was well underway, believed by many to imply a fed funds level somewhere toward 1.5%.  The best argument we have heard for a substitution of balance sheet adjustment for policy rate hikes in efforts to remove monetary policy accommodation is the expected benefit to capital investment (over consumer spending) in part resulting from a weaker dollar.

Using Inflation Language to Tweak Expectations

While it is not our base case to expect that the Fed will use the upcoming FOMC statement to signal strong desires to remove accommodation in the immediate futures (March), we are impressed enough with the elevated discussion of balance sheet reinvestment elimination and somewhat more constructive progress in both economic growth and inflation to make ourselves attuned to avenues which the Fed may use in offering meaningful policy hints. 

If the Fed were to make too strong a message of appreciation for economic prospects, a walk-back from that sentiment may cause too much confusion and cause more extensive volatility than the Fed would want.  Further, any stronger signal sent that world geopolitical conditions have brightened would appear more hopeful than instructive.  Finally, the Fed could make more pointed notice to stronger employment gains, the housing sector or capital investment than had been anticipated.  We see any more than a modest improvement in assessment of any of these areas as unlikely. 

If the Fed wishes to send a veiled message of interest in adjusting the policy rate as soon as March, it will more likely make comments about inflation as nearing its targeted level to open that door.  Focus on inflation, a relatively slow moving target, will allow Fed officials plenty of opportunity to later indicate that progress toward the inflation target has not been as steady or secure as earlier hoped for.  At the same time, if economic growth alone was to accelerate in a meaningful way, its implication for inflationary prospects will not be difficult to communicate. 

Summary

This FOMC meeting and statement are not expected to provide much excitement.  However, there is more than a minute risk that the Fed will want to push open the door for a March policy rate response.  If it is to do so, we believe the Fed will make that signal through its assessment of inflation conditions.  Otherwise, heightened interest in changes to the Feds balance sheet through reinvestment or sales of securities at a time sooner than earlier stated Fed intention is worthy of additional review.  For now, we simply imagine these discussions, especially when sponsored by Fed officials, will tend to support lower levels of implied policy rates over the coming year(s) and a steeper Treasury yield curve. 

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