Fed: The Morning After

Published on September 18, 2015
SGH Insight
“The Fed intends to undertake a major communications offensive in the coming weeks. Fed officials are likely to lay out a fairly coordinated case that a cautionary, tactical delay from a close call September first rate hike was warranted with the start to policy normalization still likely before year-end. They are likely to affirm their confidence in the economy’s underlying momentum that should drive enough job growth to slowly lift inflation as the “transitory” international downward pressures fade from the data.”
Market Validation
(Bloomberg 9/21/15) "Treasuries Fall Amid Risk-Asset Gains, Hawkish Fed Comments
10Y yield was 8.2bps higher in late trading, erasing Friday’s decline to lowest closing levels since Sept. 7
2Y yield, whose 13.1bp drop Thursday from YTD high 0.811% to 0.679% was biggest since March 2009, was 3.3bps higher at 0.710% in late trading"

Dennis Lockhart, a FOMC voter, said he’s confident rate liftoff will occur this year as markets settle down, echoing comments over weekend by John Williams, James Bullard and Jeffrey Lacker.


In the wake of the decision to wait that bit longer on a first rate hike yesterday afternoon – a decision that in and of itself was not a surprise to markets – Chair Janet Yellen and her colleagues on the Federal Open Market Committee nevertheless now have a monumental communications task ahead of them to reverse a deepening market skepticism on a rate hike any time soon and, more importantly, to prevent a broader loss of confidence in the outlook from becoming self-fulfilling.

 

*** The FOMC opted for prudence on a first rate hike in a bid for clarity on the near inflation trend and whether job growth will continue despite the global headwinds. The FOMC base case is still to start policy normalization before year-end and to use the “longer runway” until probably the mid-December meeting to monitor downside risks and, above all, to reset its policy narrative to steadily lift rate hike expectations. The policy framework, for a gradual tightening through at least 2018 with the nominal policy rate reaching a longer run neutral rate of around 3.5%, remains in place. ***

 

*** The Fed intends to undertake a major communications offensive in the coming weeks. Fed officials are likely to lay out a fairly coordinated case that a cautionary, tactical delay from a close call September first rate hike was warranted with the start to policy normalization still likely before year-end. They are likely to affirm their confidence in the economy’s underlying momentum that should drive enough job growth to slowly lift inflation as the “transitory” international downward pressures fade from the data. ***

 

*** That messaging effort, however, may prove challenging. Much of the market turbulence in the immediate wake of Thursday’s decision is driven at least in part by the perception of lost Fed credibility. There is also a mounting anxiety the rate hesitation portends a downward turn in the global outlook and that a change in the Fed’s reaction function could reinforce the very low growth and disinflation it fears from abroad. ***

 

All of this is to say there is going to be considerable attention on Chair Yellen’s speech this Thursday in Amherst on “Inflation Dynamics and Monetary Policy.” We expect her to do much of the heavy lifting need to reverse the current market psychology and to reaffirm the Fed’s base case policy path.

 

Communications Breakdown

 

On the face of it, Chair Yellen did her best to highlight the strength of the US economy. She stressed that the outlook for continued job growth, and that a steadily tightening jobs market will in time lift inflation back to mandate consistent levels. Despite the concerns over China’s growth or the spike in market volatility, the Fed’s base case outlook, she affirmed, has not been fundamentally altered by the “implications of these recent developments.” The Fed’s policy regime has not changed nor is it being questioned internally.

 

But the surprise, and the driver of much of the market turbulence today, not to mention the harsh commentary, was in what wasn’t in the statement or taken away from the presser. Indeed, it was not the decision to pass on a rate hike per se that seems to be causing so much of the market anxieties, but rather the failure of communications to better frame expectations going into the meeting and after that is now chipping away at the Fed’s credibility.

 

There was nothing in the statement, for instance, to reinforce the sense of a Committee majority consensus still moving towards an intended first rate hike no later than year-end. Indeed, if there was ever a moment an FOMC statement needed at least some forward policy guidance, this was the one; a sentence perhaps affirming that “conditions may soon warrant policy firming” or some such.

 

Instead the only major change was the insertion of the sentence pointing in the other direction, highlighting global growth and inflation concerns. And the minimal changes in the projections would suggest the Fed needs the tightening in the labor market just to keep inflation from falling further.

 

And while Chair Yellen may have said all the right things in the press conference, her tone pointed in the other direction, seeming to lack a sense of conviction affirming Committee confidence that inflation will indeed be rising back to mandate consistent levels, however slowly.

 

That takeaway was hardly intended, and it may have been a reflection of the limits on communications or when making a major policy decision by Committee when its consensus was fraying. But it means that if the FOMC is still on a path for a rates lift-off by December, it will need to help markets navigate through the potential volatility that will surround each and every data point between now and year-end.

 

There is, inevitably, going to be out-sized importance in the coming Nonfarm Payroll prints. For the Fed, a jobs number that is anywhere north of 120,000 or 140,000 at this stage in the recovery won’t move the policy needle, but for the market, anything south of the 200,000 mark will only heighten anxieties of stalling US growth. It likewise puts even more attention on China’s numbers, which are already taken with a grain of salt.

 

And if the global growth does look to be weakening, it means the US will need that much of a stronger jobs growth to offset and keep the Fed on its projected policy path.

 

The Bad Signal

 

Perhaps even more worrisome is a sense across the markets and even among other policymakers that it is Fed policy uncertainty as much as anything else, be it the weakening oil and commodity prices or doubts over Beijing’s economic policies and the pace of China’s growth, that may be undermining confidence in the outlook.

 

There are also some expressions of concern over a “competitive easing” among the world’s main central banks.  Even if the recovery in the US (or the UK for that matter) is still just shy of being fully self-sustaining, the Anglo-Saxon economies are nevertheless the only ones strong enough to even offer the prospect of a start to rate policy normalization. A stronger dollar or pound sterling that would come with it was a primary channel to absorbing at least some of the global disinflationary pressures of a still weakened Euro-zone or to offset the slowing China growth.

 

By not acting or signaling they may not be able to move, the fear among some of the other central banks is that it will force them into finding ways of further easing when they have been hesitant to go down that path. And that, in turn, could ironically reinforce the very disinflation and low growth the Fed is cautiously guarding against before it starts its policy normalization.

 

Reversing Perceptions of a Regime Change

 

Ultimately, the main target of the Fed’s coming messaging offensive will be to counter the marked shifts in market psychology and perceptions that the FOMC’s hesitation on a first rate hike marked a seminal turning point in the policy regime.

 

Try as they might to keep the path clear to a start to policy normalization this year, they will face an increasing sense of the Fed moving towards the more pessimistic secular stagnation arguments of a persistent demand shortfall and falling trend growth that precludes higher rates for a lot longer than the Fed may be currently assuming.

 

The post-meeting Fed-speak has an usual weekend start with speeches scheduled for Saturday and which will building through next week. But all the attention will be focused on this coming Thursday’s speech by Chair Yellen in Amherst, Massachusetts, where we expect her to put a firm marker down on the Fed’ base case outlook, in particular, for a slowly rising inflation as slack is steadily removed from the US labor markets, and to affirm her confidence in the Fed’s current policy regime.

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