Fed: A "Patient" Reaction Function

Published on October 3, 2014

When Federal Reserve officials kept stressing a “data dependent” policy path from here, they probably never imagined the starkly juxtaposed data that is currently unfolding.

At least until a few hours ago, the dominant theme for markets was the dovish indications of ebbing inflation and somewhat mixed data that could still turn distinctly south. Now suddenly, a robust Nonfarm Payroll gain of 248,000 jobs last month, an upward revision to the August as expected, and a five handle on the headline unemployment rate no less provides momentum back to a more distinctly hawkish narrative.

Neither, however, fully reflects where the Federal Open Market Committee consensus is heading in the near term approach to the Exit.

*** Reinforced by the handsome looking NFP, the Fed continues to see an economy on a near 3% growth track, or above trend to generate enough jobs to push the unemployment rate down and through its longer run levels next year. Wage growth was flat in today’s NFP breakdown, bolstering the case that still significant labor market slack is limiting wage gains. But the FOMC still seems likely to drop the “considerable time” language from the October statement’s forward guidance, probably replacing it with “patience” in removing accommodation, while keeping the “significant” under-utilization sentence. ***

*** The renewed low inflation is adding some heft to the arguments by dovish FOMC members against a rate hike in the first half of next year. But the low inflation prints, even with a stronger dollar and the imported dis-inflationary pressures it may bring, will not be enough to bar or even substantially delay a first rate hike. The FOMC will be willing to raise rates even with low inflation, in the belief inflation is more likely than not to trend sideways rather than to keep falling lower and threatening European or Japanese deflation levels. ***

*** Our sense is that a growing FOMC consensus continues to pencil in a first rate hike in June next year, the fulcrum around which the sooner or later messaging now rotates (SGH  9/23/14, “Fed: The Dots and the Trajectory”). Rate hikes are likewise still expected to be very gradual, especially in their initial phase to gauge the transmission into the real economy. But there will be no “measured” guidance nor a “mechanical” path to the rate trajectory, and despite market expectations otherwise, the FOMC will hike, if needed, at meetings without a scheduled Summary of Economic Projections or press conference. ***

Considerable’s Exit in October

This last week marked the showcasing of the more dovish-leaning Committee members, all of whom stressed “patience” on rate hikes in their remarks. Chicago Fed President Charlie Evans even stretched that a bit to suggest that the patience could mean a first rate hike pushed all the way back into 2016.

But even at the other end of the rate timeline, there was carefully worded coding in the more hawkish St. Louis Fed President Jim Bullard’s remarks last night. While he repeated his contention for a first rate hike as soon as the end of the first quarter next year, it was premised on if the data surprised to the upside (St. Louis is among the most upbeat of the forecasts around the Fed system). Bullard also noted that such a lift-off by the end of the first quarter next year would be deemed patience under “a standard monetary policy rule” — but which it is worth noting, the Fed is not operating under nor has it been since 2008.

But taken together, the thrust of the remarks by the various Committee members since their September meeting reinforce what we understand to be a solidifying consensus on next phase to the forward guidance, and on the likely tilt in the balance to the cost/benefit calculations on the timing to the first rate hike. The two, of course, are tightly intertwined.

First, after all the heat generated by Philadelphia’s Charles Plosser in the run up to the September meeting on potentially tossing the “considerable time” language from the current guidance, the FOMC instead opted to keep it in with Chair Janet Yellen doing her best to neuter it of its “six month” signaling significance. In any case, our sense is that a solid FOMC majority believes the October meeting statement and the end of the bond purchases is the most natural moment to drop the “considerable time” phrasing from the forward guidance lexicon.

And judging by how many times various Committee members said they can be “patient” with removing monetary accommodation, we will put a dollar on the odds that is the favored new formulation going forward. But that is probably going to be the easy bit.

The debate in fact is no longer over the considerable time language itself, but over what conditions exactly would the Committee be so patiently waiting to see before hiking? And along those same lines, will it warrant at least a modest tweak to the “significant” under-utilization of labor resources, or should that remain in place unscathed to firmly anchor a dovish tone to the “patience” in removing monetary accommodation?

The more dovish will want to tether the patience to seeing inflation clearly heading back to its 2% medium term target, since they reckon that is going to be a while, especially with the assist from a rising dollar. The more hawkish on the other hand want to see any patience explicitly linked to the steady fall in the headline unemployment rate as it edges deeper into its assumed longer run levels.

The meeting is still a month away with plenty of data between now and then — score one for both the hawks and doves in this morning’s NFP strong jobs but weak wage numbers — and there is still plenty of time to crack the thesaurus open to type up a new formulation. But when in doubt, go vague.

We also suspect whatever new language the FOMC crafts in the October meeting, it will most likely eliminate any chance of a third dissent, and may even lead to the withdrawals of the twin dissents by Plosser and Dallas Fed President Richard Fisher. No dissents and a return to a fully unified Committee would be a coup of sorts for Chair Yellen.

But it is probably also worth noting that she would be probably willing to accommodate the dissents, whatever their number and including as many as three, if that was the price to be paid in the short run to solidifying the consensus among Committee’s remaining doves and centrists on a more fundamental issue: the Fed’s reaction function to the incoming data over the next few months.

Patience Really is a Virtue

Fed officials have, of course, been repeatedly stressing how the near term policy path will be “data dependent” as its twin mandates get within reach. But as the divergence between still too low inflation and a healing labor market nearing its longer run levels of unemployment testified this morning, it is not the data that seed confusion in the market, but rather the uncertainty over Fed’s reaction to the data.

How else to explain the wide dispersion of those blue dot rate plots for fed funds by the end of 2017 unveiled in September, ranging from a mere 0.5% to as much as 4.25% in the third year of a rate tightening when the central tendency projections are not nearly as divergent?

The saga of the dots is best saved for a later day, but the quickest and easiest way to cut through them to find their most likely “midpoint” path is to bear in mind the strong tilt in the way a solid majority of the FOMC will lean in the likely cost/benefit calculations in the coming months.

The decisions on the guidance and rate hikes in the real time of each meeting from this December through next year will ultimately be based on the cost to repair the damage of a premature rate hike, a recovery potentially derailed and the risk of being pushed back to the zero lower bound, versus the potential price to be paid in being late to rate hikes and being “behind the curve” — but the curve of what?

A large majority of the FOMC still sees little, if any, prospect for a resurgent inflation in the near term, and under most of their assumptions of a still flattened Phillips Curve, it is likely to take a headline unemployment rate pushed all the way down to at least 5.5% or lower to lift wage growth up to the 4% plus levels before any sustained price pressures are likely to become apparent.

But the patience to find out just how low unemployment can go before those price pressures potentially emerge — a far more familiar risk to the Fed it is well prepared to tackle — is deemed by most of the FOMC to be a far less costly risk than pre-emptively raising rates to blunt the desired growth in employment and demand before the last leg of wages and business spending emerges.

Thus, their bet is likewise that inflation expectations are extremely well anchored, and if they should nudge a tad higher as the unemployment rate steadily moves lower than its current 5.9% reading, a rush of speeches and the statement guidance of “below normal” longer run neutral rate and the assertions of “significant” under-utilization of labor resources will be enough to keep those expectations tempered.

The Fed’s reaction function to the incoming data — short of a gangbusters surprise to the upside — is indeed going to be one of a “white of the eyes” patience in letting the economy run a little “hotter” for a while, whatever the most recent NFP print.

The willingness to keep conditions accommodative enough to push unemployment down to find just where NAIRU is — and then some — is perhaps best indicated in the 4.9% lower band of the September central tendency forecast for 2017, and even lower, at 4.5% in the wider ranges of all 13 Board and District staff SEP projections.

This, in other words, is an FOMC keen to get off the zero lower bound, but not at the risk of prematurely putting the recovery at risk. Period.

But a Willingness to Hike with Low Inflation

On the flip side of the policy equation, however, the recent downward drift again in the inflation measures, such as a core PCE print of but 1.5%, is likewise unlikely to move the needle much for the FOMC.

The persistence in low inflation beginning late last year and running through the spring of this year unquestionably garnered the wary attention of the FOMC doves (see SGH 4/10/14, “Fed: Low Inflation Angst, and those Dots”). The worry at the time was that the unexpectedly weak inflation readings amid the snow-smothered weakness of the first quarter raised enough of a deflation risk, however low its probabilities, to push the thought of rate hikes into the far distance.

That, however, began to change over the summer months as the inflation data finally began to nudge up into a higher 1.5%-2% range that was built into the forecasts. And just as today’s NFP is likely to have boosted the Fed’s confidence in the near 3% growth track, it will have also reinforced the expectations that despite its recent drift downward, inflation is still expected to trend sideways.

And even though the stronger dollar will be importing some of the dis-inflationary pressures from abroad into the US economy, its impact is still expected to be more in the way of dampening the upward rise in price pressures rather than driving inflation down still further to European or Japanese levels.

Importantly, our sense is that while this translates into buying a bit more time to let the headline unemployment rate run a little lower, it also means the Fed will be willing to raise rates when it deems the time has come even if inflation is persisting at the current low levels.

We still believe that, barring a shock to either side of the central tendency projections, the majority of the FOMC is increasingly penciling in a June first rate hike. Indeed, our sense is that the rash of dovish anxieties expressed over the stronger dollar were more about blunting the hawkish case for a first rate hike before June, not that it should translate into a rate hike delay deeper into 2015, much less into 2016.

In the current base case scenario, an inflation rate of 1.5% or so for a while, against a growth rate close to 3%, and a trend growth potential assumed to be no more than 2.3%, what is not to like if it means steady gains in the labor market with little near term inflation risk and the policy room for maneuver to begin slowly lifting rates from the constraints of the zero lower bound?

Two last points on that front.

First, the balancing act to get to a consensus on a June rate hike could come with an agreement on the timing to an end to the re-investments. Holding the balance sheet constant after those last bond purchases this month is intended to keep the effects of the long awaited tightening in financial conditions as simple as possible to better gauge its reach to the longer end of the curve and, most of all, into the real economy. The balance sheet decisions can come much later then, probably until the fed funds target range is up to or above at least 1%, maybe more, as there is no hard and fast guide mapped out yet.

But second, as one last point to end with, the FOMC will be perfectly willing to raise rates at the meetings without the SEPs or a press conference, especially after this initial first few rate hikes. To assume otherwise may cost some points here and there.

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