Fed: A Step Closer

Published on June 12, 2015

A recent string of stronger data that washed away much of the first quarter’s uncertain growth outlook is likely to frame the discussions in next week’s pivotal Federal Open Market Committee meeting and, in turn, to drive the Fed’s messaging over the summer months.

*** The winter’s mostly disappointing data are steadily giving way to a clearer picture of the economy’s underlying momentum, almost right on cue with the Fed’s post-first quarter forecasts. Friday’s Non-Farm Payroll print was nothing short of superlative, as was yesterday’s solid retail sales number. Both boosted the Fed’s trust in its forecast assumptions for a tightening labor market, steady wage gains, and a consumer spending boost to demand, all of which is bolstering a “reasonable confidence” in the forecast for slowly rising inflation to mandate-consistent levels. ***

*** Barring a downside shock, the Fed sees few reasons the job growth will stall over the near forecast horizon, and our sense remains of a Committee majority consensus continuing to solidify around a September rate hike‎ (see SGH 3/18/15, “Fed: September and a Shallow Path”). Indeed, much of next week’s debate, the first real opportunity to discuss the timing and pace to the long sought policy normalization, may center around a shift in the balance of risks from moving too soon to waiting too long, with the burden of proof falling on those arguing for delay. ***

*** That said, Fed Chair Janet Yellen is likely in her post-meeting presser to affirm the Committee’s confidence in the recovery but to shy away from explicit guidance on a first rate hike timing. She is instead likely to stress the “data-dependent” near term path, with an accent on the likely gradual pace of a shallow trajectory, in part, to steer the market away from a “tantrum” redux that might prematurely tighten financial conditions. That may be made easier by a possible downward nudge in the 2015 blue dot rate plot, but it would be a mistake to interpret it as overtly dovish. ***

Boost to Forecast Confidence

Many Fed officials have been sounding a cautious note on the outlook in recent weeks, resigning themselves to a seemingly weak rebound this spring from the snow-smothered winter months. But despite the gloomy tone of the April meeting statement (SGH 5/20/15, “Fed: Minute Expectations”), a majority of the FOMC and staff were in agreement with the declaration of Chance the Gardener in the film Being There, that “there will be growth in the spring.”

So for those Fed officials, there was nothing to dislike in last Friday’s NFP numbers. Some 280,000 net new jobs in May, a 32,000 upward revision over the previous two months, and a 207,000 three month moving average is reaffirming the Fed’s faith in an economy emerging from the chills of the first quarter, the noisy GDP numbers notwithstanding. And there are some expectations for decent upward jobs revisions by the end of the summer that may make the employment growth look even better.

The same cheer will have greeted yesterday’s very respectable 1.2% retail sales print, including the rebound to 0.7% in the retail sales “control group,” as well as strong upward revisions of March and April’s spending figures. Those numbers will likewise go a long way to supporting the Fed’s revised narrative that the expected lower oil price bump to aggregate demand was only delayed not denied, and the confidence gasoline prices will not revert back as quickly as they feel should now underpin a healthy pace of spending and retail sales through the summer.

Even more reassuring to the Fed than the handsome headline numbers themselves is how the rise, however slight, in the labor participation rate for two months running and in the average hourly earnings testifies to the Fed’s underlying Phillips Curve assumptions that lie at the heart of its forecasting models: as the labor market tightens towards or through its longer run levels, the discouraged and longer term unemployed will be drawn back into the labor force, in part, drawn in by higher wages – and in time, pushing inflation higher.

What’s more, the dollar effect on prices is also playing a role in that base case scenario. The Fed expects the downward impact of the strong dollar on goods inflation to fade if not reverse by this time next year, meaning it will no longer be limiting the upward push of services inflation on the core inflation measures. There is already the earliest of anxieties in some quarters of the Fed system that wages could begin moving higher sooner than expected.

And on that note, it is worth noting that core inflation failed to dip as much as expected so far this year. That means that when inflation is expected to be slowly moving off its current inertial levels by around this time next year, it will be from a higher level than previously assumed.

For many Fed officials, including most of the centrists, who are less willing to tolerate an overshoot of the 2% inflation target for too long or by too much now that employment is at or its mandate-consistent levels, that may mean the Fed has less running room on the massively accommodative rates than their more dovish colleagues argue, and which would warrant a sooner rather than later rate move.

Indeed, for all the emphasis on a data-defined approach to the first rate hike, it is also what the data is signaling nine months or more out on the horizon that is dictating the timing to a rate hike. Fed officials tend to stress the forecast less these days other than in vague terms — twice bitten, thrice shy on forecast misses — but we suspect there will be increasing references to how policy operates with a lag in the coming months that is essentially making the same point.

And to that point, the Fed does not necessarily need to see higher core inflation before it begins its policy normalization, only that there is “reasonable evidence” that seems to confirm the forecast for inflation slowly rising towards its 2% medium term target (SGH 5/12/15, “Fed: A Hawkish Lift-off, Dovish Trajectory”).

Assuming, then, that the pace of job gains continues through the summer, we think it is likely to be enough to clear the way for the Fed to sharpen its messaging by late August that the data is warranting a rate hike as soon as the September meeting.

The “Later” Camp’s Burden of Proof

There will still be impassioned arguments next week and through the summer for a delay beyond September on a first rate hike, that the data is just not quite there, and that there is simply too much risk in a setback to the recovery in a premature move to remove even the barest amount of the massive accommodation currently washing through the system.

It is better, and safer, the argument goes, to wait for significantly firmer evidence in the data for broad-based wage growth and for clearly rising price pressures before starting the long-awaited policy normalization. The Phillips Curve linkages between wages and inflation are so flattened in any case, it is likely to be years before inflation will become a serious threat, and if the delay for certainty on the forecast means inflation is indeed rising more than expected, there will still be plenty of time to still hold it in check.

And ever since the earliest debates over when the Fed might begin to move rates free of the zero lower bound, the more hawkish arguments within the FOMC have always been dismissed with relative ease by the dovish arguments, especially that the potentially large costs in unwinding the damage to the economy in a premature rate hike would outweigh the cost to any inflation risk. There remains the very real risk the Fed could be pushed right back to the zero lower bound if it moved too aggressively ahead of an effective real equilibrium rate presumed to be either negative or very low at best.

But our sense is that those arguments are slowly giving way to a greater emphasis on the risks to further delay. In the near term, it could stoke excesses in the financial markets or create a financial instability that could come back to wreak havoc on the real economy a la 2008, or at the far end of the forecasting horizon, driving an overshoot of inflation and being forced to raise rates so rapidly in either scenario that it derails the recovery.

By raising rates sooner than the evidence of higher wages or inflation in the data, it protects a more shallow, gradual trajectory that could extend the expansion and induce the sort of investment spending that in time lifts the economy’s potential growth (SGH 3/16/15, “Fed: Towards a Rate Path Consensus”).

There is also a tactical question that may enter into the debate next week. For one, if not September, while October is there as a fallback in theory, albeit with awkward complications, it would mostly point to December for a first rate hike. But to tighten rates in the most illiquid of months has always been a challenge, and undertaking the first rate hike in more than a decade amid an even more illiquid market with inelastic dealer inventories to absorb the likely shock of a regime shift is simply asking for trouble.

So we suspect the burden of proof on multiple fronts will be on those arguing for delay versus what we think will be a Committee majority making the case that sooner is the more prudent course to take.

The case will be made to win over reluctant doves to the sooner rather than later scenario with a consensus that the first rate hike will not be undertaken unless there is a high degree of confidence the real economy can absorb two or more hikes, and by affirming those subsequent first few hikes to around the 1% level will be taken as cautiously and as carefully weighed as the first to avoid stepping too far ahead of what is admittedly a very low real equilibrium rate.

The SEPs and those Dots

The Summary of Economic Projections for 2015 real GDP growth was already marked down by quite a bit in March, so we suspect it will be nudged down by only a little at most, say, to perhaps a central tendency range of 2.3% to maybe 2.5%. But again, with the marking down of trend growth last March, the post first quarter pace should be more than enough to continue generating jobs and removing slack from the labor markets.

The projected headline unemployment rate will probably be tweaked to fall a bit faster as well for that reason, perhaps pushing the bottom end of the central tendency narrow range to 4.9% by year-end, which would be impressive. But at the same time, we doubt core inflation will be marked down and could instead see a nudge higher for 2015.

When it comes to the almost always confusing blue dot rate plot, we always try our best to refrain from any hard expectations for where those dots may end up. Our first instinct nevertheless is that the 2015 dots might look like they are lower ever so slightly, perhaps putting into question a second rate hike this year.

Almost by default, the very hawkish dots that were still absurdly high in March at around 1.5% by year end — five hikes this year! — will be marked down, but more discerning eyes are going to quickly go to the row of “0.625 dots” to see whether the core centrists are backing away on September, or more likely we think if there is a nudge down by one or more of the dots, displaying some hesitation on a second hike before year-end in December.

That in any case could potentially create some communications complications that Chair Yellen would have to quickly address as the FOMC may not necessarily want the market to be assuming in June an explicit Fed signaling of no rate hikes until the end of the year. But in any case, we are still wondering whether any movements lower of one or more dots might be offset by others being nudged up that could effectively make the 2015 dot movements a wash.

As to the dots beyond this year in 2016 and 2017 — and we will see the 2018 dots in September — they seem likely to be similarly marked down to reflect the shallow rate path most of the Fed is now embracing. For the most part, however, we will take them with a grain of salt, more as an indication of a best case path for the appropriate policy path in a perfect world, and far less as an indication of where rates are indeed likely to be at the end of those years.

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