In the end, it was a pretty straightforward risk assessment decision captured in the money sentence of the statement that “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” In other words, it would seem the Federal Open Market Committee has been taken aback by how long and how uncertain the inflation outlook has become.
*** The FOMC concluded it could not start policy normalization in September as it had hoped due to the heightened uncertainty around renewed global disinflationary headwinds. While Chair Janet Yellen made a halfhearted effort to leave the door open to October rate hike, it seems very unlikely. The long runway to December still looks to be the FOMC’s base case for a first rate hike, assuming growth does not falter. But the tone and language of both the statement and press conference suggests the Committee consensus is fraying somewhat, and that the FOMC could be resigning itself to the possibility for a first rate hike delayed into 2016. ***
*** Despite median headline unemployment now expected to reach as low as 4.8% in 2016 – at least four or more staff forecasts have unemployment as low as 4.5% next year – and Chair Yellen’s vow of faith in the Phillips Curve linkages that very tight labor markets will underpin an upward turn in core inflation, or that the low oil price and strong dollar effects will prove “transitory,” the persistently low inflation is clearly throwing the Fed’s assumptions into doubt. The return to the 2% medium term inflation target has been moved back by at least a year to 2018, at the earliest. ***
*** The tightening cycle is now expected to stretch even more gradually than ever, with rate increases projected by almost all the Committee members to continue into 2018 and even then, with perhaps half the Committee members not expecting to hit the longer run neutral rate — that has again been lowered sharply — until, one assumes, in 2019. Perhaps even more dramatically, the assumed longer run neutral rate has been marked down again, by quite a bit, with a dozen Committee members now at no higher than 3.5% and even all but one of the traditional hawks putting their longer run neutral under 4%. ***
A Persistent Low Inflation Risk
For the most part, the Summary of Economic Projections were pretty much in line with our sense going into last week that the projections for real growth would be marked up for this year, unemployment nudged down further, and core inflation barely adjusted at all (SGH 9/14/15, “Fed: When in Doubt, Move the Pawn”). And indeed, 2015 growth was even marked up by quite a bit, to a new median of 2.1% from 1.9%, underscored by the statement noting economic activity is “expanding at a moderate pace” with household spending and business fixed investment “increasing moderately” while the labor market “continued to improve, with solid job gains and declining unemployment.”
In fact, the projections across the forecasting horizon were not all that different. And Chair Yellen did assert the Fed’s base case outlook has “not fundamentally altered” and warned against overplaying the implications of the recent uncertainty in global growth and disinflationary pressures. The assumption is still for the tightened labor market, in time, to underpin that steady upward pressure on prices. And that much-sought upward turn in core inflation is indeed still expected to start showing up in the data next year.
We take that to mean that for the Committee majority, the base case for when to start policy normalization has been simply moved back a quarter to December, just as September was moved back a quarter from the June rate hike penciled in for most of last year.
Indeed, Chair Yellen reaffirmed that the desire to begin policy normalization with a first rate sometime this year still stands. With inflation taking a little longer to begin its ascent, a start to policy normalization before inflation is indeed rising in order to protect a long, gradual and shallow trajectory works just as well with a start in December as it does in September, especially when looking at a three year plus tightening cycle.
And whatever risk there is in an even bumpier take-off in the longer runway, its cost is still seen as lower than the cost in repairing the damage in a premature hike if there is anything to these rumblings of stalling global growth and renewed deflationary impulses in the market gyrations. The delay is worth the time gained to perhaps get a sense of whether the near outlook is darkening or not.
A Hit to Forecast Confidence
Nevertheless, despite the minimal downward tweaks to the forecasts, it is clear that the FOMC’s confidence in their base case has taken a hit. Despite the gains in unemployment and above trend growth, in other words, there now seems to be a shortfall in the labor market’s upward pressures via higher wage growth and the time it will take for core inflation to reach its 2% medium term target that has been now pushed back by at least a year into 2018.
That would suggest an affirmation of the arguments long made by Eric Rosengren, President of the Federal Reserve Bank of Boston that the rise in core inflation is going to take longer than what was being assumed in the previous central tendency forecasts by the Board and other District staff. And that persistence in core inflation will leave the economy vulnerable to a potentially costly disinflationary if not deflation risk if a downside shock should derail the above trend growth.
So for now, our sense is that a scenario looks to be creeping into the FOMC’s policy calculations that the same framework and reaction function that applies to a December first hike may equally apply to a first rate hike slipping into 2016. If for any other reason, there could be very little change in the story narrative of the data that comes in between now and going into what could still end up to be a contentious mid-December meeting.
That, in turn, is going to put a very heavy burden on the Fed’s messaging in the next few weeks, and indeed through the rest of this year to push the market expectation and pricing back onto a high likelihood for a year-end rate hike.