When Federal Reserve Chair Janet Yellen was asked in the Q&A session after her speech last Wednesday at the Economic Club of New York whether there was a change in the Fed’s reaction function, she fumbled a bit but said no.
We are still scratching our heads a little on the answer, and suspect that it will be a subject of future speeches in due course. But whether by default or by design — and it seems more the former — a happy confluence of several intersecting developments seem to have come together in March that do seem to look and feel like a change, or a tweak at least, in the reaction function.
*** First, there is a clearly elevated sensitivity to global risks. It draws in part on a heightened risk management tilt to downside concerns when rates are still so close to the Zero Lower Bound. But it is also rooted in a somewhat belated awareness of how quickly Fed policy can be transmitted abroad through an outsized exchange rate channel, especially when inflation and interest rates are so low or negative. Subsequent market dislocations and capital outflows, when coupled with weak growth abroad, can rapidly ricochet back in a stronger dollar and diminished risk appetite, potentially weakening US growth and inflation. Caution necessarily becomes the watchword. ***
*** Second, there is an understanding that successive bouts of this adverse feedback loop have become a key feature of the Fed’s policy normalization, from the 2013 “taper tantrum” to the pullback in September last year before the eventual December rate lift-off. This time, still scarred by January’s volatility, cautious in the uncertainty over China’s outlook, and assisted by a further reduction in the projected longer run neutral rate, the Fed was able to pre-emptively minimize global downside and spillover risks by slowing the pace of projected rate increases this year from four to two rate hikes. ***
*** And finally, despite the dovish market pricing in response to Yellen’s speech — which was not intended to be as dovish as it was taken — we still believe a June rate hike (this year!) should not be ruled out as a possibility, if not probability. The dynamics of inflation through this year will ultimately be a key driver to the policy debate and pace of rate hikes through 2016. But barring significant Brexit volatility or a downward deviation in the data, it is our sense there is a fairly widely shared FOMC consensus, among hawks and doves alike, to raise rates once this summer, followed by an extended pause to a second rate hike by year-end. ***
Elevated Global Risk, and now Brexit
International risk factors was clearly a key driver to the Fed’s policy caution so evident in March. Chair Yellen certainly put an accent on “significant” global risk factors in the “greater gradualism” of her speech last Wednesday, a speech widely taken across the markets as so aggressively dovish it seemed to run contrary to the Fed’s self-described “data-dependent” policy path. Friday’s all around solid Non-Farm Payrolls print only seemed to underscore a credibility question.
But the Fed’s sensitivity to global risks is not entirely new, and has been building across the system for some time, certainly since last August’s market dislocations. There was that sentence inserted into the September statement highlighting global risks, for instance, and Board Governor Lael Brainard followed through with a high profile speech highlighting the international aspects to policy in mid-October. And January’s violent global market sell-off then truly brought the international risk factor to the forefront of the policy caution.
Long before January, however, there had already been a greater focus inside the Fed on the implications of the transmission of US monetary policy through the exchange rate. With so much of the more traditional transmission mechanism like the interest rate sensitive sectors of the economy clogged up by the battered housing market, impaired balance sheets, or the lack of access to credit, it was becoming increasingly apparent the dollar was becoming an out-sized channel in transmitting much the Fed’s massive accommodation abroad, and especially so when interest rates and inflation worldwide were so low.
More to the point, the same transmission effects can and are flowing in the other direction when policy began being reversed, however gradual and well telegraphed. And when coupled to the slowing economic growth abroad, and more specifically in China, it was inevitable that the Fed would have to take those international factors into account to protect a still vulnerable US recovery.
What’s more, the effects of the exchange rate — and oil price volatility — are no longer about the slower-moving trade effects or the competitive advantages of a weakening currency. Instead, almost immediate and frequently savage adjustments in market risk appetite can quickly translate into a stronger dollar, lower equity prices, and higher credit spreads.
Witness the dislocations and tightening of credit conditions last August and again in January. The market re-pricing was almost certainly excessive but the Fed had to be careful not to validate the pricing or to push it even further with a rate hike. If those downside risks were to be sustained, financial conditions would tighten and soon have a material effect in slowing US growth and bringing renewed downward pressures on prices. Which is what January was threatening.
“Ideally, we want to get ahead of that,” Yellen noted last week.
That desire to get ahead of looming global risks may soon be put to the test again in the run up to the June 23 Brexit vote. All else being equal — a loaded phrase if there ever was one — it is our sense a rate hike will be on the table at the June 14-15 FOMC meeting, even if Fed officials and the Chair in particular will have their work cut out for them to shift market expectations and pricing to position for a rate hike.
But if the UK polling in the weeks running up to both the mid-June FOMC meeting and the Brexit vote the following week is pointing to a decent probability of a UK exit from the European Union, it could easily prove near-impossible for the Fed to be messaging its intended policy normalization in a global environment that still seems anything but normal.
Risk Management and a Lower Longer Run Neutral
Market volatility would nevertheless have to be significant to sway the Fed’s policy path, but its possibility points to the risk management calculations that now play a major role in the Fed’s policy normalization path. It dials back to what former Fed Chairman Alan Greenspan used to refer to as a Bayesian risk management approach when making policy decisions amid an unusual degree of asymmetric risks and uncertainty (on that note, it is interesting that Chair Yellen inserted the word “Uncertainty” into the title of the final version of her Wednesday speech, to make it “The Outlook, Uncertainty, and Monetary Policy”).
This risk management weighting is pretty straightforward: if moving rates too slowly in the near term allows inflationary pressures to build further down the road, the cost of correcting that policy error is far easier and “cheaper” than its opposite, moving too quickly and ending up in a scramble to find the right mix in a return to unconventional policy measures that are likely to have a limited, if not diminishing return. And keep in mind those too low for comfort inflation expectations.
One last factor playing a major influence in the more dovish, pre-emptive March meeting base case rate path and perhaps Yellen’s dovish speech was an unusual convergence across the Committee to further lower their estimates of the longer run neutral policy rate.
While Chair Yellen described the change in March as “small,” the new median of a 3.25% neutral rate compares to a 4.25% median just a few years ago in a projection that was rarely changed at all in the previous decades. All the more interestingly, both the compression of the rate dot projections in 2016 down to two hikes from four, and the lowered neutral rate were made going into the meeting, not as an outcome of the discussions at the meeting.
In some sense it was inevitable as something of a follow through on the previous downgrades in the estimates of the economy’s trend growth to perhaps no more than 2% from well over 3% just a few years before; after all, how else to explain the steady creation of net new jobs throughout the last few years when growth has been barely this side of tepid?
The lower neutral rate implies a lower terminal point to a rate tightening trajectory and carries significant signaling meaning in suggesting that rates may run lower than “normal”– a point Chair Yellen made sure was inserted into every FOMC statement since March 2014.
But many FOMC members are also concluding the central bank won’t need to raise rates as much to have the same intended effect in tightening financial conditions: each hike is that much more potent and that, in turn, reinforces the impulse to be cautious on the pace of policy normalization