Federal Reserve Chair Janet Yellen was unmistakably more upbeat on the US economic outlook in her remarks last Thursday than she was in her very dovish speech at the Economic Club of New York the week before. And while caution remains the policy watchword, the direction of that messaging is telling.
*** Fed officials are well aware of the very dovish pricing in the market’s takeaway from the Chair’s New York speech, which itself was a follow through on the more dovish rate path indicated in the March rate dot plot. But Yellen’s remarks last week were, we suspect, a modest pivot back to a more “centrist” policy positioning which, in turn, creates some messaging running room in the weeks to the April Federal Open Market Committee meeting. And if data stay in line with the projections — the CPI and retails sales this week stand out in relative importance – it opens the door to using the April statement to signal a rate increase will be on the table at the FOMC’s June 14-15 meeting. ***
*** The Fed’s messaging path to a June rate hike may replicate the sequencing to the December 2013 start to the QE taper, and last December’s rates lift-off. In each case, the Fed managed market volatility by tactically backing away from a relatively hawkish stance in the face of market volatility to reset a more dovish foundation to an eventual, extremely modest tightening. With the added layer of a greater awareness over the global effects of its policy moves, the Fed’s bet here would essentially be that the same template will work to position market pricing by the time of the FOMC’s mid-June meeting if the Committee consensus remains in place for a rate move. ***
*** Indeed, while global risk and the Brexit factor will continue to keep the FOMC majority tilted to caution, it remains our sense there will be a Committee consensus to raise rates by the mid-June meeting (SGH 4/15/16, “Fed: A Pre-emptive Reaction Function”), assuming as always, the data stay on track and there is relative market calm. While few Committee members believe there is a pressing inflation risk, there is some concern among a majority that going too long before a next rate move could force a faster than desired pace of hikes down the road, or even draw the entire architecture of the policy normalization strategy itself into question. ***
No Pre-Set Course
Chair Yellen and her Committee colleagues make a point to continually stress how current policy is not on any pre-set course, that each meeting is “live,” and that the policy path is “data dependent.” And amid the unusual degree of uncertainty over the outlook — and the interaction between monetary policy and market pricing — there is an added layer at present in the overlay of risk management considerations when the asymmetric costs of a policy error tilt so much to the downside.
But all that said, Fed rates policy is not entirely data dependent (nor is every meeting really live) in the sense that the data is not taken in isolation but interpreted within a framework built around the policy normalization strategy; each step along the current path could be a hike, a pause, an extended pause (“greater gradualism”) or even a reversal, but its direction remains a steady upward progression that as gradually as necessary removes the massive monetary accommodation in place since the taper that ended the increases in policy accommodation.
The decisions at each meeting in that sense are tactical, driven by both what the data seems to be signaling about the economy, the balance of risks around the base case forecast – and the market’s pricing and sensitivity to the Fed’s policy signals. It is this last piece of the policy puzzle that is drawing closer scrutiny among Fed officials in the wake of last August and January’s more recent market dislocations that threatened a turn for the worse in the US recovery and abroad.
Chair Yellen made a point of noting how much the market’s dovish pricing on the path of rates relative to the Fed’s December four hike projections for 2016 helped to defuse the potential damage in the severe dislocations of January and the first half of February. But the market re-pricing was led in large part by the Fed’s own more overtly dovish signals, then confirmed in the March meeting dot plot that saw the number of rate hikes downshifted from four to two hikes for a mix of reasons (see SGH 4/5/16, “Fed: A Pre-emptive Reaction Function”).
Though there was a messaging misfire the next week by some Committee members — who for the most part were stressing the “every meeting is live” message but pressed a bit too too hard on April in the process — Yellen’s speech before the Economic Club of New York marked the culmination of that messaging reset begun in mid-February.
In accenting the Fed’s sensitivity to the downside global risks to global economy and the asymmetry of the risks to the US recovery when still so near the Zero Lower Bound, the messaging reset successfully shifted market sentiment. It may be a data dependent path, but it is still a path where the Fed is defining the terms along the way.
The task now before the Fed if the data is supportive of a next move in the policy normalization is how to nudge the market pricing out of its excessively dovish pricing.
A Template Twice Used
The pathway to managing market expectations and pricing has already been played out on two previous occasions, the first in the taper tantrum period of 2013. After yields spiked that summer on the shock glimpse of the QE bond purchases being brought to an end, the FOMC passed on the start to the taper in September, repositioned market expectations through a better messaging of how policy will remain highly accommodative even as the taper slows the increases in accommodation, and the taper was launched without a hitch in December that year.
Nearly the exact same sequencing was undertaken in the run up to last December’s historic rates lift-off. The months through early August were marked by a consistent message that a start to policy normalization loomed before year-end, but the FOMC passed on a widely expected September move amid the uncertainty generated by that August’s market volatility.
The policy messaging then took a distinctly more dovish tone, calming markets and allowing more time for positions to be adjusted over the months after a hawkish tilt was inserted into the October meeting statement. By December, the market smoothly took the end to seven years of zero rates with barely a ripple.
This time, our sense is that the FOMC is looking to follow the same template in the run-up to June, the initial conditions for which were set up in the March meeting and the combination of the Yellen speech and subsequent remarks alongside the three other former Fed chairs on Thursday.
That said, for now it is only the early stages of a messaging positioning to ensure there is the option of moving rates again by the time of the June meeting. Data and, increasingly, market calm are necessary pre-conditions. And there doesn’t seem to be the same degree of certainty building this spring that there was in the run up to the December rates lift-off last fall.
The data, for one, while healthy with still resilient job creation, is nevertheless somewhat more uncertain, with the strength of the first quarter GDP drawing a watchful eye. And of course those fragile global conditions hang like a cloud over the US outlook, pushing risk management calculations to the forefront.
On the other hand, the consensus within the Committee for a near rate move is, we think, stronger than generally assumed. The more dovish-leaning Committee members, for instance, who did not necessarily want to see a rates lift-off in December but were nevertheless resigned to it, have this time round been pleasantly surprised by how quickly the rest of the Committee came down to their 2016 two rate hike projections. And they are perhaps even more pleasantly surprised to be standing more at the center of the Committee’s range of views, rather than stage left.
Above all, while multiple threads of the more pessimistic secular stagnation are increasingly being weaved into the Fed assumptions and forecasts — indeed, to the point of a narrowed distinction between the two competing narratives — the FOMC consensus is still solidly behind the policy normalization strategy.
Greater gradualism is not the same thing as abandoning the policy normalization framework altogether. And indeed, there is some concern that too long a pause between the first and second rate move could bring the entire architecture of the normalization process into question.