Fed: A Dovish Lean

Published on January 27, 2016

This afternoon’s Federal Open Market Committee statement read to us to be about as neutral and as carefully crafted as it could possibly be. The FOMC wordsmiths seem to have gone out of their way to avoid giving too much to validate any of the market pricing or chatter of looming recession even as they acknowledged global risks; and they likewise clearly refused to explicitly signal March is off the table.

*** While the statement, as we expected, may not have gone far enough to validate market expectations, it did on balance read with a modestly dovish lean in the near term. March is still on the table to be sure, but persistence in low inflation and the delay in the anticipated base effects of the dollar and oil prices dropping out of the data will mean a fairly high bar to jump to a rate hike by the mid-March meeting. ***

*** But perhaps more importantly in the longer term, the FOMC made a significant change in the “Statement on Longer-Run Goals and Monetary Policy Strategy” that underscores their determination to pursue a policy normalization path that will be paced as gradual and as accommodative as needed, even if it means overshooting the 2% inflation target. ***

March Optionality

In the near term, March is still on the table, bolstered in the statement language affirming an economy still marked by “strong job gains” and in a rearranged opening sentence framing recent weakness with the accent on a labor market that “improved further even as economic growth slowed;” and in case you missed the importance of the labor market to the policy calculations, they added a third mention that there was an “additional decline in underutilization of labor resources.”

Household and business spending were modestly toned down but were still “increasing at moderate rates while housing “improved further.” Even if weak growth abroad kept exports “soft” and “slowed” inventory investment, it is still a description of economic activity that hardly points to recession risk and, in general, to a rate path that still suggests the next move is up, not down.

To be sure, though, the FOMC noted it will keep an eye on “global economic and financial developments” in a nod to the September caution, and that is “assessing their implications for the labor market and inflation, and for the balance of risks to the outlook.” They did shy away from a definitive view on whether those risks are balanced or not, but the door is clearly open to a shift back to a downside risk if the data turns south against the forecast.

But most of all in terms of the Committee’s near term risk/reward calculations, it was significant to us that the Committee finally explicitly conceded “inflation will remain low in the near term.” Yes, they remain confident those ongoing “transitory” factors will in due course fade from the price measures, but that phrasing confirms to us the bar to a March rate hike is indeed higher than it might have been when they laid down the base case four rate hike path for this year in the December rate dot plot.

As we noted earlier this week (SGH 1/21/15, “Fed: The View in January”), that won’t necessarily preclude a rate move as long as the labor market remains healthy, but it will take a very confident Committee and a very solid consensus to push ahead in March if there is little to hang a hawkish hat on in the inflation and inflation expectations measures.

A Significant Change to the Longer Term Reaction Function

But what really leapt out for us was the near Committee consensus to tweak the “Statement on Longer-Run Goals and Monetary Policy Strategy.” It is something we also suggested in our last report was possible (SGH 1/21/15, “Fed: The View in January”), but frankly thought they might shy away from since changes in the annual statement are meant to be rare and taken only after considerable debate.

In the December statement the FOMC had already put a strong accent on their concerns over the persistence in low inflation and especially that they were watching for any further erosion in market and survey-based inflation expectations measures. It would have therefore been difficult to find a way to double down on that in the January statement.

But in inserting an explicit declaration in their longer run statement that the 2% inflation target is indeed symmetrical and that the “Committee would be concerned if inflation were running persistently above or below that objective” the Fed took a hugely important step in signaling its likely reaction function once those transitory factors repressing underlying inflation finally fade out of the data.

The FOMC majority generally believes that even with the economic growth of the last few years that the underlying core inflation is probably running at around 1.7% or so. So the question is what the FOMC is likely to do when the downward dollar and oil price pressures finally do drop out of the inflation measures: will the rise in the core inflation back to that 1.7% or 1.8% level in effect be near enough to the 2% target that the FOMC will start weighing whether to quicken the pace in the rate tightening trajectory?

This formal re-assertion that the inflation target is indeed symmetrical and is not a ceiling would suggest that the FOMC as a rule will be willing to let inflation run above the target or that they now feel less potential need for rapid rate hikes to protect inflation credibility if inflation finally starts to move more quickly towards its mandate-consistent levels, and that, in turn, means the “sooner and slower” rate path can be even slower if needed.

Indeed, the entire objective in the “sooner and slower” rate policy path started in December is to build in plenty of flexibility throughout a long three year tightening cycle envisioned, including a willingness to see inflation overshoot the target, albeit probably not for long or by all that much since by then the Fed will be close to a presumed longer run neutral policy rate.

Above all, we suspect that once the willingness to overshoot the 2% inflation target sinks in, the FOMC is also hoping it will help to temper any further declines in longer term inflation expectations.

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