Fed: A Honeymoon’s Second Doubts

Published on May 22, 2018
SGH Insight
We would first caution that this base case consensus is a relatively fragile one. There remains an undertow of dovish doubt still pulling the Committee consensus towards caution on the pace of rate hikes, at least until data breaks more clearly. There are, for instance, fresh doubts over the scale of the fiscal stimulus, that it may “fizzle out” after 2019, and whether the Fed may need to “look past” the assumed price pressures it will bring. And while inflation is widely expected to modestly overshoot its twice-repeated symmetrical 2% target, there remains a concern it could still peak and then ebb again rather than persist.

Market Validation
(FT 5/23/18)
Treasury yields slip after ‘dovish’ Fed minutes

Investors bid up short-term US government debt after a detailed account of the last Federal Reserve meeting was judged as leaning towards the dovish end of the spectrum.

In recent trade, the yield on the policy-sensitive two-year Treasury note fell 5.6 basis points (0.056 percentage points) to 2.5363 per cent. The yield, which moves in the opposite direction of price, traded at the lows of the day roughly 30 minutes after the release of the minutes from the central bank’s May meeting.

Further down the maturity curve, the US 10-year yield was down 5.9 bps at 3.0063 per cent, but it had not knocked out the lows set earlier in the day.

With the Memorial weekend and the traditional start to the summer months fast approaching, the Federal Open Market Committee is by all accounts on a glide path to a widely expected June meeting rate hike. Affirmation of the gradual pace of rates policy normalization, three hikes this year with the optionality of a fourth, is very likely to shape the policy messaging going into the June meeting and, if they are lucky, right through the summer.

That’s the base case anyway, but we would make four points to layer that with our sense of the Fed’s near-term messaging and what we would describe as Chairman Jerome Powell’s desire for something of a honeymoon period until, say, September, before the FOMC would need to firm up its policy consensus:

*** We would first caution that this base case consensus is a relatively fragile one. There remains an undertow of dovish doubt still pulling the Committee consensus towards caution on the pace of rate hikes, at least until data breaks more clearly. There are, for instance, fresh doubts over the scale of the fiscal stimulus, that it may “fizzle out” after 2019, and whether the Fed may need to “look past” the assumed price pressures it will bring. And while inflation is widely expected to modestly overshoot its twice-repeated symmetrical 2% target, there remains a concern it could still peak and then ebb again rather than persist. ***

*** We would not necessarily put the current policy debate within a traditional dove versus hawk framework, but more in terms of probabilities and how the data could potentially swing the center of the Committee. Data could still come in to support the case for continued rate hikes into an outright tightening and a probable inflation overshoot. But, for now, we suspect the Committee consensus barely goes much beyond the next rate hike to a third rate hike in total this year that would put the fed funds target range at 2%-2.25%, or very close to short run R* estimates. And without clear evidence of a rising short run R*, the consensus to go further on rate hikes would seriously begin to fray. ***

*** Indeed, we suspect an extended debate over the neutral rate will run like a central thread through the FOMC May meeting Minutes, and that this debate is likely to continue through at least through the summer. The caution over how policy may need to be carefully assessed in the approach to neutral is also likely to color the debates in the May meeting minutes tomorrow over the signaling in the shape of the yield curve, and in seeking to define the limits of a symmetrical inflation target, as well as the approaching need to tweak the policy messaging in the statement or the frequency of post-meeting press conferences. ***

*** Barring a surprisingly strong string of near term data, we think revisions of the fiscal impact could mean at least some of the June growth projections are marked down rather than up, albeit probably more evident in lower ranges rather than the median. And as we think the bar is probably becoming relatively high for rate hikes beyond the next two when so close to the short run neutral, without confirming data on an inflation persistence, the June rate dot projections may flatten a bit in the later year forecasts and instead be extended into 2021, which would become evident in the September projections. ***

The Backstory to Powell’s Patience

The Fed’s base case policy path has been well laid out over the recent months in a rather smooth hand-off from former Chair Janet Yellen’s carefully crafted Committee consensus to that now taking shape under Chairman Powell, who is still awaiting Senate confirmation of new Board appointments by the Trump Administration, including of Vice Chairman-designate Richard Clarida.

That said, it is hard not to notice that after a relatively hawkish first testimony on Capitol Hill last February, Chairman Powell ‎has since been consistently more cautious in his remarks on the probabilities to the Fed’s rate path, something we have highlighted in recent reports (see, for instance, SGH 4/4/18, “Fed: Powell’s Caution” and SGH 4/6/18, “Fed: A Patient Approach”). 

Powell’s low-key way in his first post-meeting presser in March, for instance, in shrugging off the dot plot’s outright tightening by 2020 as “highly uncertain” and even adding “I wouldn’t put too much into that” still rings in our ears. And it is striking how often Powell’s assertion that “there’s no sense in the data that we’re on the cusp of an acceleration in inflation” has since been repeated by other Committee members.

The reason behind the caution, we believe, is that the Chairman is seeking something of a long honeymoon period, through the summer to perhaps the September meeting, to let the data play out before committing the Committee to a rate path along the lines of that mapped out in the March meeting rate dot plot. What’s more, our sense is of a lingering uncertainty on a number of fronts in the forecasts, which translates into caution over the rates trajectory and its terminal point that may lie behind Powell’s patience, at least until there is clearer evidence of firming and rising inflation.

The first is some revisionist analysis of the likely impact on growth and demand in the twin fiscal stimulus of the tax cuts and the fiscal boost to spending. For one, the timing to its impact is now likely to come much later than initially expected, really not until the fourth quarter this year, making it more of a 2019 rather than 2018 story.

The impact of the tax cuts, for instance is for now still uncertain and exceedingly difficult to model into the economic forecasts, in large part because the new rules on how the new tax laws will actually work are still being written by Treasury. That, in turn, besides opening up massive budget deficits down the road, means many of the assumed incentives for business investment or small business growth are still up in the air, delaying any of the assumed impact on demand and certainly on the supply side. 

Meanwhile, on the budget boost to spending, federal agencies may prove to be unable to spend as much as the bill allows for the fiscal year ending in September, for instance, and Congress has yet to write much less pass any of the actual 12 spending bills needed for the coming fiscal year. So aside from the intended jolt to defense and non-defense discretionary spending in the top line to FY2019, it is next to impossible to model exactly how long the extra spending will last or where it will leave its mark on demand. 

For those reasons, our sense is that at least some if not many of the projections that will go into the June meeting Summary of Economic Projections may see the growth forecasts modestly marked lower, not higher. 

Along the same lines, there may be enough anxiety over the uncertainty created by confrontations over trade to translate into a caution on growth projections. Already, many districts are hearing anecdotal evidence of delays to investments until there is greater clarity on both the trade and tax fronts. The agriculture sector, meanwhile, is already under stress, with the spring planting season already well underway. Some initial business surveys are also yet to show much evidence of firm plans to increase capital expenditures.

A Still Uncertain Inflation Dynamic

Those revisionist updates to the growth outlook inevitably are feeding into lingering questions over the evolution of inflation. After the years of undershooting the Fed’s target, and despite an ever tightening labor market, inflationary pressures in the US economy still appear to be quite inertial, with still very few signs now or on the near horizon “we are on the cusp of accelerating inflation,” as Chairman Powell noted in his March presser and many other Committee members have since repeated.

With the most recent measures of inflation, including the core PCE and a favored Dallas mean trimmed measure, all showing inflation very near its 2% target, the assumption is rightly that it is likely to keep rising to slip above the symmetrical target at some point this year. In an ideal world, though unsaid explicitly, most Fed officials hope it will settle in in a range between 2% and an upper threshold of 2.5% for a few years. 

Fed officials are in near unison in asserting there is no intention to engineer such an overshoot of the inflation target even as they emphasize how symmetrical the inflation target is. Even to say they will tolerate an overshoot is a nuanced term: they after all didn’t exactly tolerate the undershoot of the target these last six years or more, they simply couldn’t hit it. 

With all the fiscal stimulus, even if delayed, and an extremely tight labor market, it does not take a sophisticated forecasting model to imagine at least some upward pressures on wages and on margins, meaning companies will at minimum test their pricing power in the coming months. 

Indeed, higher service sector inflation and increased prices that hold are showing up here and there, depending on the state or the sector, and higher inflation may come in waves, even if dragged out. Many companies have been successfully using energy and commodity cost increases to pass on higher product prices, in an indication of how inflation expectations may be slipping higher.

But the momentum to those evident price pressures is still uncertain. And price pressures confirmed in the data, rather than just “conforming” to the slack-based forecasts, may be what a majority of the Committee, including the leadership, is now needing to see. 

Adding some weight to that patience is a sense of safety that the underlying inflation trend will still be slow moving, and having already brought the policy rate so near neutral the Fed will still have ample time to keep gradually removing the last of its accommodation to blunt inflationary pressures before they approach an unspoken upper band of 2.5% — in other words, the Fed has already acted preemptively.

And indeed, for now, the balance of risks in the medium term, is still “roughly” balanced, in that while there are clear risks to the upside if the fiscal stimulus is as large or larger than initially believed, tariff threats to trade or a fiscal boost that may simply fizzle out after a year or a little more of pop may also mean the Fed will need to “look through” near term pressures to an inflation dynamic beyond that may ebb and drift downward again after briefly overshooting the target.

All of this would have to be seen in terms of probabilities rather than firm forecasts or a certain Committee consensus. And key data points in the run up to the mid-June meeting — next week’s Non-Farm Payroll print in particular — may go a long way towards bolstering the case for nudging rates well beyond any short run neutral level or to elusive “fourth” rate hike this year.

But for now, there is enough uncertainty to the outlook for a “middle ground” that Chairman Powell spoke of and, we think, for a June meeting dot plot that may well hold at a three rate hikes median for 2018.

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