In a testimony to how successful Federal Reserve officials have been in telegraphing their balance sheet plans, most of the market attention going into this week’s meeting of the Federal Open Market Committee isn’t on the balance sheet at all, but rather on the likely signaling about a December rate hike and where the rate dots in 2017 will be.
*** On those rate dots, despite the dovish remarks by several Committee members in recent weeks, we think it is very unlikely the median projections for rate hikes this year will drop to zero. There will be some downward drift in the 2017 rate projections, but we strongly expect the median to display one more rate hike this year. The rate dot plots will, however, probably drop across 2018 and 2019, reflecting the renewed doubts across the Fed system about longer run neutral levels. But the most interesting thing about the 2020 rate dots, unveiled for the first time, may be how many are marked above the assumed neutral levels, indicating an outright tightening. ***
*** We think the statement will see a reaffirmation that policy is still accommodative and that a gradual rise in rates remains appropriate. Chair Janet Yellen will strive in her press remarks to be balanced in how she frames the rate debate going forward, careful to keep the Committee’s rate policy options open by avoiding comment that would rule out a near hike. She will certainly give voice to dovish concerns over the persistence in low inflation and the possibility of a new inflation dynamic emerging, but on balance, we still expect her to modestly tilt her remarks to a base rate path that, all else being equal, would warrant a possible third rate hike in December. ***
*** One reason the Fed’s base case still leans toward a continued gradual pace of rates normalization, that may include a third rate hike in December (SGH 6/14/17, “Fed: Still Betting on Mr. Phillips”), is the lack of a persuasive policy framework to the alternative narrative of a new low inflation dynamic. The Fed is many things but above all it is a conservative, collegial, consensus-based institution slow to change its beliefs and core assumptions on how the economy and the inflation process works. Data alone in the months before December will not be the deciding factor, and policy will not be hostage to a single data series, even if as central to the current debate as the various inflation measures. ***
The Ongoing Inflation Debate
The unexpected drop in the core inflation measures through the middle of this year and the questions it raises over the Fed’s most basic assumptions about the dynamics of the inflation process (see SGH 7/5/17, “Fed: Return of the Inflation Question”) has been coursing through the FOMC’s policy discussions across their last few meetings, especially at its most recent at the end of July.
It is likely to once again in September, and it will no doubt dominate the questions the press will pepper Chair Yellen with at her post-meeting presser. We would note, of course, that the Fed has the luxury of seeing how data and the competing explanations and narratives play out through at least the end of October meeting, after which Fed officials will want to begin a reasonably coherent and ideally consensus messaging going into the December meeting.
But September, even if the intended emphasis is on the balance sheet, is likely to go some way towards framing the policy debate over the behavior of inflation and the pace of rates normalization.
We would also add that the divide between the dovish-hawkish camps within the FOMC is in fact a very fine one, with caveats threaded into the arguments on both sides that could tip either camp to the other as the data comes in through the rest of this year. For instance, even the most hawkish will back off any thought of a near hike if they come to believe inflation expectations are indeed falling and vulnerable to becoming dangerously unanchored to the downside. Likewise, a sense of a still lower NAIRU or an economy evidently being able to run with an even higher labor utilization but without the slimmest of price pressures would at minimum tip the balance within the Committee towards perhaps waiting until March next year before pressing ahead with rates normalization.
In any case, there is now a solid minority of at least five FOMC participants openly challenging the internal mainstream assumptions about the inflation process. It initially began last year when St Louis President James Bullard and his research staff abruptly abandoned the more traditional forecasting models to adopt a “regime-based” forecasting that is more or less rooted in an assumed persistence of low inflation.
Chicago’s Charlie Evans has wondered aloud in recent speeches whether technological changes have altered both the supply and demand side of price formation, while Dallas Fed President Robert Kaplan has distinguished between cyclical factors that could indeed be “transitory” and a more substantial, structural underlying inflation dynamic that is running lower than in previous expansions.
Fed Governor Lael Brainard picked up on that theme in a well-argued recent speech asking whether there is a sliding, slow moving, underlying trend inflation currently running lower than before the crisis, that is to say, a more persistently lower R* or equilibrium interest rate not yet captured in flattened Philips Curve linkages or fleshed out yet in a comprehensive new framework. Bullard might add on that by arguing the persistence in low inflation stems at least in part from the extended period of low rates, which in turn leads to embedded low inflation expectations and a cycle that becomes difficult to reverse while the risks of a policy overshooting are high.
And more tactically, another of the dovish arguments that will probably be cited in September and laid out in the policy debate in the coming weeks is that the two “front-loaded” hikes in March and June, right after December’s lone hike in 2016, were meant exactly for the purpose of maximum flexibility to pick and choose the timing to subsequent hikes in the second half of this year.
The Fed is in a much more advantageous situation than they were in 2015 and 2016 when the risk management calculations made them hesitant about the timing to possible rate moves, and with the Committee chasing the data for a rate hike before year-end each time.
Now they have much more flexibility to weigh whether the drivers to inflation have indeed fundamentally changed. If there are any doubts over the timing, even if there is no doubt over the normalization strategy, the burden should be on those arguing against waiting another quarter to see firmer evidence of inflation in the data.
The Base Case Scenario Still Dominates
The FOMC majority will argue the rate decision can’t rest on just a single variable in just the inflation prints, a point many of the doves would probably concede since it risks tying the Fed’s hands, certainly in its policy messaging. Instead it has to be based on the overall state of the economy, as Cleveland President Loretta Mester has often noted, and the softer than expected price pressures do not seem to reflect a weakening of demand or growth falling below trend.
And more to the point, until the data proves them otherwise, the Committee majority envision a confluence of cyclical and more fundamental drivers to inflation coming into place by next spring or summer that will see inflation rising more clearly and cleanly towards the 2% mark.
For one, they really do believe most of the current downward pressures on prices are “idiosyncratic” and transitory, and will be rolling out of the 12-month data by late spring or so of next year. At the same time, better growth abroad and the soft dollar this year should remove the downward effects on goods prices by next year. That of course will be coming into play as the economy keeps to an above trend growth, continuing to tighten the labor market whose headline unemployment rate could be pressing against the 4% mark. At some point next year, that kind of “high pressure” economy will finally be exerting the anticipated upward pressure on wages that businesses may be increasingly pressed to pass on through higher service and product prices.
And that is before the Trump reflation of a next spending/tax stimulus may have to be layered back into the forecast after most of the staff had stripped it out by spring. Inflation expectations seem just as likely as not to stay well anchored.
What’s more, since policy operates with those “long and variable lags” (that assumption we would think needs to be reconsidered), it means the Fed must act on the basis of the forecast, not the most recent data point, and above all, to judge where the greater risks lie down the road amid a near constant state of uncertainty.
Taken together, these factors fit within the current policy framework and it in effect trumps the FOMC’s policy choices premised on a still uncertain “new” theory of inflation dynamics.
And that in fact may be, for now, the biggest weakness to the dovish argument — at least in terms of weighing the probabilities on the timing to a next rate hike. There is still the absence of an alternative framework from within which to model out these new inflation drivers. And without one, on what basis would a conservative, collegial, consensus-based institution like the Fed abandon its current assumptions and forecasting process to embrace a new unknown?
In other words, the policy messaging and eventual December rate decision will be predicated on the forecasting process as it is currently structured, continuously tweaked and adjusted to the incoming data but still built around the statistical regularity of the Phillips Curve, which despite its shortcomings, still stands as the best conceptual framework with which to distinguish noise from the signal in the data.
And the Balance Sheet Rundown
Lest we forget to mention, the centerpiece of the September meeting will of course be the start to the Fed’s well telegraphed “passive and predictable” balance sheet normalization. The first asset run-off will probably come at the end of October. By January, the initial $6 billion and $4 billion a month in run-offs of treasuries and MBS will be laddering up by equal amounts over the next four quarters to bring the combined monthly run-off to $50 billion.
In theory, the balance sheet could be down to around $3 trillion by 2020, though the rundown could end at a higher terminal level. Reinvested assets will be rolled over in proportion to the Treasury’s auction schedule.
In any case, the September start to shrinking the balance sheet will mark a noteworthy achievement for Chair Yellen in crafting a consensus for such a major reversal from nearly a decade of extraordinary policy measures expanding the balance sheet. It will also be an impressive platform from which Vice Chair Stan Fischer will make his exit next month.