Fed: A Turn, of Sorts

Published on November 26, 2018
SGH Insight
While a dovish-sounding turn of phrase may find its way into the Chairman’s speech, we suspect the thrust of his remarks will be less about near signals, dovish or otherwise, than it will be to prepare market expectations for the uncertainties to the rate path beyond the still likely December rate hike. Our sense is of a lean within the FOMC favoring a pause, if possible, but as rates reach or near an estimated neutral level next year, the data-driven rate moves could also quicken or stay at the same gradual pace in what is still an upward tilt to the FOMC rate consensus.
Market Validation
(WAPO 11/28/18)
Federal Reserve Board Chair Jerome H. Powell on Wednesday suggested the central bank could slow the pace of its interest rate increases, saying rates are now just slightly below what he considers a “neutral” level.

His comments marked a sharp change from his position last month, when he said the Fed still had a “long way” to go before it reached that equilibrium.
U.S. stock markets soared on Powell’s comments, as he appeared to signal that the Fed would not move forward aggressively to raise rates much further than it already has. The Dow Jones industrial average pushed up 500 points, an increase of nearly 2 percent, a surge that erased its November losses and put it back in positive territory for 2018.

Still, by saying rates were slightly lower than the level he perceives as “neutral,” Powell’s statement appears to be suggesting at least one more interest rate increase is coming in the near future.

The recent downward stock market turbulence has had the talking heads on CNBC clamoring for relief from the Federal Reserve while the speculation over slowing growth has pushed fixed income markets to begin pricing in fewer and lower odds for rate hikes. With those market anxieties as his stage backdrop, Fed Chairman Jerome Powell will enter the spotlight this Wednesday when he speaks before the Economic Club of New York.

We would offer three main points as a preview of sorts to Wednesday and which we think will be shaping much of the policy debate going into the December 18-19 meeting of the Federal Open Market Committee:

*** While a dovish-sounding turn of phrase may find its way into the Chairman’s speech, we suspect the thrust of his remarks will be less about near signals, dovish or otherwise, than it will be to prepare market expectations for the uncertainties to the rate path beyond the still likely December rate hike. Our sense is of a lean within the FOMC favoring a pause, if possible, but as rates reach or near an estimated neutral level next year, the data-driven rate moves could also quicken or stay at the same gradual pace in what is still an upward tilt to the FOMC rate consensus. ***

*** One of Powell’s intended takeaways may also revolve around what a data-dependent rate path, stripped to a minimalist guidance, would mean for the market’s traditional role in the price discovery process. In a “normalized” policy stance, market pricing would invariably have to incorporate a wider range of possible rate paths, which by definition should mean greater volatility and a higher term premium. In effect, we think Powell may seek, cautiously, to move away from, not toward, the reassuring “put” so many in the market will be straining to hear. ***

*** We would add, if Chairman Powell doesn’t, that the uncertainties shaping the rate path are not just in how the data may play out — whether the fiscal stimulus fades or if trade war effects seep into inflation expectations are two that come to mind. Even more importantly, the Fed’s policy framework is undergoing an evolution due to new views on inflation dynamics that are changing the contours of the policy debate. In addition, a wider definition of imbalances to include financial excesses as well as inflation is likely to feature more prominently going forward. ***

The Pause Debate

We have always thought a pause of two or more FOMC meetings in the pace of the current upward rate trajectory was possible, if not probable by next spring or summer (SGH 11/16/18, “Fed: A Premium on Policy Flexibility”). But the possibility of a pause — which we would define as a pass on a rate increase through at least two or more FOMC meetings — is not the same as a given, and even then, an extended pause is not the same as an end to the rate tightening cycle.

The current Committee consensus for a continued pace of gradual rate hikes only extends to the policy rate being brought into estimated levels of neutral levels. The Fed’s sense of neutral ranges from as low as 2.25% to well over 3% and even higher, and with a reduced reliance on the “celestial stars” incorporated into the forecasting models, the FOMC will essentially be feeling the way through the data for neutral.

Philadelphia President Phillip Harker recently indicated he still needs to be convinced about a December rate hike. He is not a voter, but we suspect Harker — who has become something of bellwether to the Committee consensus, a role played by former Atlanta Fed President Dennis Lockhart —  was putting more of a marker down on the shape of the debate by the March or May meeting in which the case for another rate hike will be more fiercely debated than on December.

The highly likely December rate hike would put the target federal funds range up to 2.25%-2.50% and into the lower range of estimates. That is already above the estimates of the FOMC’s two lonely doves, James Bullard and Neel Kashkari, the Fed presidents of the St. Louis and Minneapolis districts.

If the data by spring is showing a marked slowdown in the pace of job creation, or especially if inflation is showing no signs of picking up in momentum, Harkin, Bullard, and Kashkari would be likely joined by Dallas Fed President Robert Kaplan and Atlanta’s Rafael Bostic in resisting another rate hike. All else being equal, under those conditions, they would argue it would be better to cautiously pause on further rate hikes in order to assess the lagged effects of the cumulative rate hikes.

What’s more, both Vice Chairs Richard Clarida and Randall Quarles also opened the door to a pause in recent remarks, and Chairman Powell himself recently acknowledged potential headwinds next year, including the possible drag on growth in the rate hikes to date, taken as an indication of his willingness to weigh a possible pause next year.

Add to that the recent cautionary messaging by New York Fed President John Williams of “somewhat” higher rates on the horizon, or Clarida’s “some” further gradual rate increases, and it is clear the Fed is at minimum seeking to soften somewhat the more hawkish shock of Chairman Powell’s casual mention in early October that the Fed was “a long way from neutral, probably,” that certainly got the market’s attention.

Headwinds and a Possible Renewed Tailwind

We would caution, however, that when Powell more recently noted several headwinds on the horizon when he spoke earlier this month, it was not necessarily signaling any odds for a Committee decision for a pause in the pace of rate increases.

Global growth, for instance, does seem to be slowing, and the effects of the trade wars may boomerang back to the US, undermining growth next year. But trade wars can turn on a impulsive moment or the first signs of economic stress, while the slower growth in Europe is mostly about Germany, and its exports to China, whose own slowing growth rate may still be tempered, as Beijing still has policy options for additional stimulus at its disposal if needed.

So whether a global growth slowdown will be sustained remains to be seen, and whether it would be enough by itself to alter the trajectory of US growth is even more open to debate.

The far larger driver to the most likely rate trajectory next year is whether the domestic fiscal stimulus of the December 2017 “Tax Cuts and Jobs Act “and the February 2018 “Bipartisan Budget Act” will begin to fade through the second half of next year as currently assumed across the Fed SEP real growth projections.

Even if growth does look to be slowing next year, the median three rate increases penciled into next year are already assuming the diminishing upward pressure on labor and capacity demand as the fiscal stimulus fizzles out. In other words, a modestly slowing growth rate may not be enough to convince the FOMC it can afford to relent on further rate increases, or even pause, until it more clearly sees the underlying inflation dynamics.

What’s more, of course, as we first forewarned some months ago (see SGH 9/10/18, “US: Midterms, Trade, and a Fiscal Accelerator“), there is a more than an even chance the Democratic-controlled House could bring the White House along to another fiscal boost in the Fiscal Year 2020 budget.

In time, that would more or less eliminate the Fed’s assumed fade in the fiscal boost to demand and an ebbing inflation penciled into the September Summary of Economic Projections. And that, in turn, would starkly reverse the rate dot plot projections tapering back on the pace of rate increases next year and in 2020.

Evolving Views on Inflation Dynamics

Indeed, it is our sense that the uncertainty and evolution of inflation is in fact perhaps the core issue for the FOMC in weighing its policy options next year. The underlying inflation trend is expected to gently rise to a modest overshoot of the 2% inflation target before the fiscal stimulus is expected to fade enough to stem any further momentum. That ebbing momentum to inflation is essential to winning a FOMC voter majority over to a rate pause, much less an end to the rate hikes, next year.

The Federal Reserve Bank of San Francisco recently noted that the long-sought rise in core inflation to the 2% mark was being driven by a strong upward pressure in the more non-cyclical, industry-specific and structural components of the inflation measures that are less sensitive to the state of the economy. Its contribution could become more difficult to dampen as economic growth and demand pressures ebb, but on the other hand, there is likewise an implicit downside inflation risk if there is little left to its momentum from here.

Ironically, the pro-cyclical inflation components that are more sensitive to the state of the economy have so far failed to contribute to the higher inflation as much as expected. That suggests an even higher upside inflation risk if the economy fails to cool as much as projected next year.

This uncertainty over the inflation dynamics of course inevitably points to the great debate over the Phillips Curve that has been threaded through the Fed policy discussions ever since inflation failed to fall as much as expected in the depth of the Great Recession and equally, a failure to rise much above anything beyond a lengthy sideways persistence of low inflation right until last year’s fiscal stimulus.

But however sidelined it may have been in recent years, the Phillips Curve continues to provide a useful if not essential conceptual framework for the Fed forecasting process in helping to identify anomalies in the data and the means to strip away data noise for the prized signals of underlying trends. 

More to the point, it still features prominently in the hawkish rate stance of perhaps a majority of the FOMC (see SGH 11/16/18, “Fed: A Premium on Policy Flexibility”). So while it may be flattened in recent years, for many of the Committee like Cleveland’s Loretta Mester, it may soon be steepening and finally pressing the underlying inflation higher as expected.

The two lonely Committee doves base much of their skepticism over further rate hikes on their rejection of meaningful Phillips Curve effects on inflation. And Chairman Powell himself noted in Sintra last summer that “alternative forces may be influencing the inflation process.” Vice Chairman Quarles even expressed some doubts over whether inflation is even a useful barometer anymore of where the neutral or equilibrium policy rate lies, which is nearly tantamount to tossing out most of the current policy framework.

The Phillips Curve assumptions, then, are less useful in guiding to exactly when the so far highly inertial inflation will begin to gather greater momentum.  And inflation’s largely still inertial dynamic has led to a wider debate over whether the Fed should be factoring in to a greater degree the “alternative” drivers to inflation, firmly anchored inflation expectations and global deflationary pressures among them.

The Financial Stability Factor

And finally, the uncertainty in the Fed’s base case rate path next year is not only reflecting both potential data surprises as well as the evolving views within the Fed over the inflation forming process, but also to what degree financial stability considerations are being phased into the policy debate over rates.

Powell has made numerous references to financial imbalances in his remarks since becoming Chairman, most notably in his “celestial stars” speech at Jackson Hole last August when he declared “risk management suggests looking beyond inflation for signs of excess.” And he has in fact shared a concern with former Fed governor Jeremy Stein on the financial stability factor in the rate policy calculations.

Indeed, it is not lost on many if not most FOMC members, including the Chairman, that in recent decades — most painfully in the 2007-2009 Great Recession — that the excesses in an overheating economy first surfaced in financial asset price inflation well before traditionally better understood goods and services inflation.

In that sense, the recent turbulence in the stock market would not be entirely unwelcome by Fed officials who would tend to see a lessening in the risks to financial stability, not a cause for a “Greenspanian” softening in the policy stance; hardly the makings of a “put” to the stock market declines.

The question that we think will be increasingly threaded through the policy debate next year may revolve around whether a long period of low rates and persistently low inflation in goods and services can in fact lead to financial excesses that build over time, only to break in a sharp “asymmetrical snapback” in the stretched stock market valuations or in term premia reversing from ultra-compressed lows.

Fed officials have been careful not to overstate their watchful eye on asset prices, in part for fear it would be mistaken as targeting asset prices. And there are limits to how far Powell or other Fed officials can go in laying out a clearer picture on the financial stability calculations in rates (and balance sheet) policy, namely because the Fed still lacks a resilient and reliable understanding of the linkages and channels between asset prices and the real economy, or how to identify and then formulate an appropriate, perhaps pre-emptive, policy response.

Nevertheless, we expect the Powell-led Fed to increasingly ask not just whether unemployment can run too low when weighing their risk assessments and rate calculations, but whether in a longer policy horizon asset prices can go too high in driving imbalances that could bring down the economy.

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