First things first, the Federal Open Market Committee’s policy statement was well crafted in its balance, even polished, with something for everyone and impressive in being a unanimous decision. And we would have to note what was a superlative delivery this time by Chair Janet Yellen in the press conference.
*** Our main takeaway from the afternoon is an FOMC affirming its confidence in the recovery, messaging the expected gradual and shallow path in the trajectory of coming rate hikes – but on its terms and ceding little ground to the market’s fixation on a very dovish rate scenario or pessimism on the outlook. The Committee, we think, is seeking to realign expectations in the new year to bring market pricing closer to the Fed’s base case path of up to but probably not more than four rate hikes next year. And whether that proves to be the case, the FOMC is clearly wanting to keep a March rate hike on the table if the economy stays on track with the central tendency forecast. ***
Reversal of Roles
The Fed messaging was pretty much in line with our expectations (SGH 12/9/15, “Fed: Defining Gradual”), but the role of the statement and the rate dot plots of the Summary of Economic Projections were reversed, with the formal statement carrying most of the carefully balanced but dovish leaning messaging on a likely gradual and shallow rate path rather than a more aggressive nudging down in the projected rates of the rate matrix.
In the statement, the more dovish voting members got just about everything they could have wanted in laying out a gradual and shallow policy path – albeit in their meaning of the words, not the market’s – with very dovish affirmations of a gradual pace and that it will be a shallow trajectory “below levels” expected in the longer run; policy will remain highly accommodative for some time; an acknowledgement that inflation expectations have “edged down” and are no longer as stable – something of an important warning indicator for the doves – and a sense of caution in moving forward with future rate hikes in light of the persistent “shortfall” in inflation.
But hawks not only got their hike, they managed to get the policy flexibility they sought by not getting the FOMC too locked into high bars to the next rate hikes, in that the pace will ultimately be dictated by expected as well as actual inflation and by the economic outlook (i.e. the forecast) as well as the data; there was a recognition of how much policy operates with a lag, and; for all the overall dovishness in the statement, there was nothing to suggest a “one and done” rate pessimism still so pervasive in markets.
We suspect the key to the wording of the statement was its final version being drafted and approved only after the Committee saw everyone’s dot projections. Even though the rate dots in each of the three years compressed, and the overall range of the dots did edge lower, the new medians introduced as a guide to the center of the consensus were unchanged in the 2016 median, and only edging slightly lower in 2017 and 2018.
And likewise though the estimates of the longer run neutral rate were modestly nudged lower, the median remained firmly at 3.5%. So the dots, in effect, by coming in a bit higher than what would have made them an optimal messaging vehicle, meant that the statement rather than the dot matrix had to carry the burden on the intended gradual messaging.
In her just over one hour appearance before the press to explain the FOMC’s thinking and assumptions going into the day’s announcements, one theme that stood out to us was Yellen’s remarks on inflation.
Yes, the Fed will want to see be sure of inflation rising, but Yellen pushed back against any high hurdle to jump before raising rates next year. There is no “simple formula” to how the FOMC will take inflation’s performance into account when weighing a rate hike, only that they want to see the data pointing towards their expectations of inflation moving higher through next year. It is a slightly but significantly lower hurdle to further rate hikes than needing to see clear evidence of higher inflation in the data moving up to 2%, and in any case, she also indicated the FOMC is pretty confident they will indeed see inflation moving higher next year, as the anticipated transitory effects of the dollar and oil fall out of the data.
On the oil question, for instance, Chair Yellen reaffirmed that the Fed will not need prices to rise or to go up much, they only need to stabilize around the current levels for the headline and, in time, core inflation to move up in the data through next year. Indeed, she reaffirmed the Fed’s firm belief in the transitory effects of the oil prices, pointing to the evidence in the higher oil prices in 2004 and 2008 that quickly faded out of the data. On the dollar, it has appreciated a lot to date, but that it came up so little in either her remarks or questions from the press was tantamount to reaffirming that its downward pressures on inflation will prove transitory as well.
She likewise affirmed that the FOMC is in no rush to end its reinvestment policies, not “until the normalization of the level of the federal funds is well underway.” It is our sense, though unsaid today, that this will translate into keeping the balance sheet at its current size — which should also “help to maintain accommodative financial conditions” – until at least early 2017, by which time the FOMC is assuming they will have enough rate hikes out of the way to both assess their effectiveness and to be reassured there is enough of a rate “buffer” in case a reversal in policy accommodation is needed.
It was also noteworthy that it took a full hour into the press conference for a reporter to ask about upside risks; all the questions were otherwise all about the downside risks, but which Yellen patiently addressed and tempered in what she said were balanced risks going forward, repeatedly pushing against any door being opened to the pessimistic “one and done” outlook for rates and the economy. “This marks the end of an extraordinary seven year period,” Chair Yellen declared confidently, and indeed she seemed downright confident in the economic outlook, which was what she probably intended as the real takeaway to the historic decision taken today.