Fed: A Hawkish Lift-off, Dovish Trajectory

Published on May 12, 2015

For all the hand wringing over how soft and how persistent the first quarter slow down would be, it would seem Friday’s Nonfarm Payroll was still good enough to bolster Federal Reserve confidence the rebound remains on track, albeit at a slightly slower pace than it did last spring, but still driving a steady tightening of the labor market through the rest of this year.

And against the backdrop of renewed market volatility these last few days, Federal Reserve officials are adopting a new messaging tact that the market should look to the data, as they are, for guidance on the most likely timing to that first step towards “policy normalization” with the long awaited lift-off in rates.

*** We still believe that a September rates lift-off remains the base case for the Federal Open Market Committee, and if anything, the Committee consensus for September is solidifying rather than migrating towards later this year, while it would probably take the Second Coming to move the lift-off forward into June. And even with the less explicit forward guidance going forward, it will nevertheless be a well-telegraphed rate hike to limit volatility that may be building in the run up to the rates lift-off. Chair Janet Yellen’s remarks last week about equity market valuations and low term premiums are best seen in that context. ***

*** The mantra of a data-driven policy from here notwithstanding, the timing to that first rate will not be based so much on where the data are by late summer, but where they indicate the economy will be by around this time next year. The Fed still expects the strong dollar and lower energy price effects to have faded and stronger wage growth to be nudging core inflation up by around the spring of next year, and a FOMC majority want fed funds nearer to 1% than zero by then as the best insurance against near term rapid rate hikes that might upend the markets or a longer term overshoot of the twin mandates. ***

*** If the recovery should falter, the Fed policy messaging is more likely to first continue stressing the gradual tightening cycle before conceding a later rates lift-off. Indeed, to bring along a solid Committee majority consensus by September, and to offset the risk in a premature tightening, rates policy and its messaging is being built around the base case for a unprecedentedly long, shallow, and unpredictable rate trajectory, neither measured like 2004 nor rapid like 1994, and in which the second or third hike will be as cautiously taken as the first to assess its impact on the markets and the real economy. ***

A Lukewarm Rebound

Gone are the heady days of noting “solid” job gains in the statements as the FOMC did late last year. Indeed, in the weeks going into Friday’s NFP, Fed officials were becoming increasingly resigned to a much more moderate if not lukewarm rebound this year compared to last spring’s strong rebound.

That was already apparent in the growth downgrades in the March Summary of Economic Projections, along with a lowered estimate of the economy’s trend potential growth. And the April statement simply noted that “economic growth slowed during the winter months” but without an encouraging word on a brighter outlook; that stands in sharp contrast to the more upbeat April 2014 statement already highlighting that “growth in economic activity has picked up recently.”

In line with those lowered expectations, while Friday’s 223,000 jobs number at least dispelled the gloomier anxieties over a reversion back to the subpar growth of prior years, the April NFP print, coupled to the downward revision to 83,000 in March, marked a downshift by nearly a third to less than 200,000 jobs a month compared to the 280,000 pace in job creation in the last half of last year.

What’s more, April’s job performance is probably going to mark the pace of job creation through much of this year, while an apparent bulge in inventories carried over from the first quarter will undercut second quarter prospects, perhaps limiting GDP growth to 2.2% or a bit better.

The primary drivers to the more subdued jobs outlook were twofold: the first was the more forceful and sustained impact of the stronger dollar on the domestic demand than had been forecast (you live, you learn), and most of all, the apparent reluctance of the once mighty American consumers to spend all their found money in the dramatically lower gasoline and energy costs.

The recent survey by Visa that more than two thirds of Americans still distrust how long the lower gasoline prices will last caught the eye of more than a few Fed officials in reassessing the assumptions going into the forecasting models, and the best bet now is that they will keep those dollars in the bank until they feel a bit more comfortable gasoline prices stay moderately lower this summer or ideally, that their real income is at least stable if not rising.

Little wonder, then, that Fed officials will tend to stress the “momentum” in growth from the second quarter on rather citing an annualized GDP growth number dragged down by the slow start this year. They are likewise likely to tweak their optimistic take on that momentum with a modest downgrade to a “near” 2.5% to 3% pace in growth.

Silver Linings

But before drawing too dark a picture from the data, it is important that for a Committee majority, there are silver linings threaded throughout the most recent NFP that offer a brighter hue to the outlook.

For instance, the labor participation rate bumped up a bit, to 62.8% from March’s 62.7%, in particular among the 45-54 year set. While not exactly a burn-burning uptick, it neatly fits into the forecast narrative of a slowly expanding labor force as the labor market tightens, despite secular trends to the contrary.

Positive employment growth for the 25-34 year-olds is likewise boosting the Fed’s confidence in the forecast for decent demand gains that should provide a boost to housing as well. And while the gains in average hourly earnings were still tracking at a far from impressive 2.2%, wage gains aren’t really expected to start climbing until late this year; a last leg of the expected labor market healing that, in some sense, would upend the current base case policy path if the gains started to build now rather than later.

And while the US consumers are not spending their extra cash as freely as much as the forecasting models said they would, it is still nevertheless “delayed” demand rather than no demand. Energy goods and services now account for just under 4.5% of consumer spending compared to just over 5.5% a year ago, and the second round effects of the lower energy costs have still to really show through in the data. The much-sought spending should pick up if gasoline prices more or less stabilize through the summer driving season, while the steady decline in the headline unemployment rate should add to the consumer sense of job security.

Add to that an ebbing dollar effect in undercutting exports, a sustained reversal in Europe’s deflation scare and a looming turn in its growth outlook, and the increasing likelihood of higher federal spending here (the Republican-controlled Congress may talk deficit reduction but we are pretty sure they will be spending liberally, especially on defense, see SGH 12/8/14, “US: A Modest 2015 Fiscal Tailwind”); taken together, they are all tallying up in the growth column for later this year and into next.

So assuming the pace of job creation doesn’t significantly falter from here – a low probability in the Fed’s eyes, but it is a critical caveat to be sure – there is still enough growth north of the economy’s trend potential to generate a continued decline in the headline unemployment rate towards and through its assumed longer run levels. From this perspective, most Fed officials are becoming more comfortable with this more moderate, somewhat tepid growth.

And we believe that despite the persistence in the market pricing pushing a first rate hike towards the end of the year, a September rates lift-off is still the base case among a majority of the FOMC and it, in turn, is lending shape to the pace of the rate tightening we suspect will draw further elaboration in the upcoming remarks and speeches by Fed officials.

Benefits of a Gradual Trajectory

We have noted in previous reports (most recently, in SGH 3/8/15, “Fed: Getting There”) that the FOMC majority wants to “protect” a gradual rate tightening trajectory in some sense as the best means to ensure an extended economic expansion that draws higher business investment spending and lifts productivity. That, in turn, as Fed Governor Jerome Powell noted in a speech last month, will go a long way to repairing some of the supply side damage to the economy caused by the immense demand shortfall in the wake of the 2008-2009 crisis.

There is also a near term benefit in a gradual rates ascent in that by endlessly stressing the rate hike is coming but that it will be unusually gentle may dampen some of the market volatility and perhaps induce a more controlled, manageable rise in term premiums (well, good luck on that). And by slowly withdrawing the massive monetary accommodation over several years, it may also help the central bank avoid rapid rates hikes at the far end of the tightening cycle to prevent an overshoot by too much or for too long of the 2% inflation target, which the Fed is no longer willing to engineer now that the prior “lower for longer” policy stance has succeeded in pushing unemployment to near NAIRU levels.

There is one other reason, and an essential one, for what is likely to be a cautiously gradual trajectory, which was laid out by Chair Yellen in her San Francisco speech a little more than a month ago. In particular, the distinction she made between the effective equilibrium rate and the longer run neutral rate charted in the SEP blue dot rate plots was another way of fleshing out on the remaining guidance that has been in the FOMC statement since it was inserted in March last year, Yellen’s first as Chair, that the fed funds rate is likely to be “below normal” for some time even after mandate-consistent levels of employment and inflation have been achieved.

The former is crucial to determining the pace of the policy normalization in the current real time of policy decisions, whereas the latter is where policy will be in perhaps three years or more. But for now, the Fed can only “normalize” nominal interest rate policy at a pace that tacks as closely as possible to the estimated effective real equilibrium interest rate as it slowly rises towards its longer run levels.

To move prematurely risks pushing the economy back into a subpar pace or recession as the secular stagnationists warn; but a delay by too long — say, to wait for further confirming evidence wages and inflation are rising as expected — would put the benefits of the gradual trajectory at risk by stoking excessive volatility or financial instability, which was the point Chair Yellen was making in her remarks last week at the IMF, and which was a bit unusual for her to do after playing down the financial stability factor for so long.

Yellen Channels Stein and Plosser

Yellen has in fact not only been recently echoing former Fed Governor Jeremy Stein on the financial stability front, but she has also been sounding a lot like former Philadelphia Fed President Charles Plosser in her recent remarks by stressing that policy operates with a lag, and that the Fed essentially needs to make its rate move well before wages or inflation show up in the data.

Starting the policy normalization “sooner” is some sense a hawkish move in order to protect the more dovish pace after lift-off, and it also provides a highly prized, maximum tactical flexibility to respond to developments in the financial markets and the real economy.

That is why several FOMC members, most notably Vice Chairman Stan Fischer in remarks last month, have stressed how the upcoming policy normalization is likely to be unprecedented and unlike any previous rate cycle. It certainly will not be a measured pace as in 2004, and it may include extended pauses, or be bunched up if the data allows it, and it could even reverse with a cut before a renewed ascent. It will just depend on the Fed’s careful, cautious assessment of its effects on the markets and how it filters into the level of activity in the real economy.

And that will especially be the case during the first few rate hikes. The second or third rate hike will be as exhaustively weighed as the first, even though the first would not be undertaken until the fed forecasters are pretty sure the real economy can safely absorb two or more.

The financial market is another issue altogether, of course, and this may well be why the new Fed messaging is attempting to wean the markets off the Fed’s every word, in the hopes the market itself will “normalize” in providing a signaling function again.

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