Federal Reserve Bank of New York President Bill Dudley’s speech in Beijing the other day all but put the kibosh on a Federal Open Market Committee rate increase at its March 15-16 meeting. That is not surprising in itself, since the odds have been shrinking for some time now (see SGH 1/27/16, “Fed: A Dovish Lean”), and the market has never really bought into its likelihood at all.
*** We would, however, caution against reading too much into Dudley’s soothingly dovish words or those of other Fed officials stressing downside global risks. For one, a Non-Farm Payroll this Friday more or less in line with, or stronger than, current expectations will tip what we think is a developing Committee consensus to limit the likely rate pause at the March meeting to a tactical one. Indeed, barring a lackluster NFP print subsequently followed by a shock southern turn in what has otherwise been reasonably resilient US economic data, a June rate hike is very much on the table, even likely. ***
*** It is not a fear of recession or a resignation to the few if any rate hikes this year the market is in fact currently pricing that is driving a consistently dovish tone to many recent Fed remarks. Rather, our sense is that in opting for what is an almost certain “prudent pause” on a March rate hike, the FOMC is simply taking a page straight out of the risk management playbook, much in the way they did last September. In this case, a March pause in the gradual upward rates trajectory of policy normalization could be followed by a hawkish signal in April, then followed by a second rate hike in June. ***
*** In other words, we think there is a fairly solid Committee consensus going into the March meeting that amid so much uncertainty and market volatility and however low the FOMC majority believes the probabilities, if the weakness in global growth and disinflation were to spill over to swamp the US recovery, and especially if market and survey-based inflation expectations were to decline any further, the cost in reversing the damage is simply too high compared to any cost in a modestly faster than expected upward turn in inflation. ***
The NFP and the March Meeting
A lot of attention will obviously be focused on this Friday’s NFP, which most private sector forecasts are putting at around 195,000 new jobs in February and a headline unemployment rate holding steady at 4.9%. That is more or less where the Fed forecasters are, though it has to be always stressed that the numbers would need to truly veer well south or north of that sort of outcome to alter the Fed’s base case path for a steadily tightening labor market. On that note, there is likely to be a particular scrutiny in taking apart the data for further signs of what should be a modest rise in the participation rate and perhaps wage growth.
Short of a shock turn south in the jobs numbers, the NFP is more likely than not to reflect the still fairly resilient data points of recent weeks: decent retail and home sales, higher personal spending, even better-looking new orders for big ticket durable goods; there was a modest upward revision to fourth quarter GDP and a Federal Reserve Bank of Atlanta “GDP tracker” is putting the first quarter GDP growth at a near 2% pace.
Further bolstering the Fed’s base case outlook of above trend growth this year and the steady tightening in the labor market is the higher inflation in the 1.7% core PCE print and the early signs of wage growth in last month’s NFP breakdown. Faith in the Phillips Curve would appear to be vindicated.
That surprise jump in the inflation measures is likely to level out in the coming months, the Fed believes, but will then steadily pick back up through the year as the effects of the strong dollar and weak oil prices drop out of the data, a point Vice Chair Stan Fischer has stressed in his recent speeches.
If anything; that the inflation measures in the first month of the year are already at the levels the FOMC projected for year-end is an observation certain to be duly noted by the more hawkish Committee members in the meeting in two weeks’ time.
But set against that is the tightening in the financial conditions since the turn of the year amid still volatile markets, and the darkening clouds on the global horizon, which several Committee members like Dudley and Governor Lael Brainard have highlighted. The question going forward, the Committee will debate at their mid-March gathering, is which of the two juxtaposed economic trendlines will prevail?
For now, the Committee majority seems to be betting on the resilience in the US domestic demand growth.
And while the easing by, well, all the main central banks in Europe and Asia, is set to underscore the policy divergence between the Fed and their actions, the Fed is, for now, still betting the eventual convergence in policy rates will come later, not today, and up towards the Fed rather than down to the exploration abroad of negative rates and where that effective lower bound truly lies.
That is a world the Fed simply does not think likely in the US, nor is it their policy option of first choice if the outlook should make an unlikely turn for the worse.
A Watchful Eye on Inflation Expectations
One last point worth emphasizing is that very real anxieties felt by hawks as well as doves in the unwelcome declines in the broader survey-based consumer and business measures as well as the more pessimistic market-based measures of inflation expectations that is weighing on their confidence in the resilience of domestic growth, and that Phillips Curve kicking in.
Fed officials have tended to discount the market-based declines in inflation expectations, due to the technical factors like liquidity or the market’s well-established tendency to overshoot on just about everything. But the point at the moment, however, is that the reason for the market declines is no longer terribly relevant, and even if the survey-based expectations are still “more stable,” they are nevertheless still declining, and both are at the bottom end of anything at which a solid majority of Fed officials would feel comfortable with.
There is a very real reason a solid FOMC majority is watching inflation expectations, in that those “transitory” downward pressures of the strong dollar and weak oil prices are persisting a lot longer than expected, and the delay in that long-awaited base effect of the dollar and oil factors dropping out of the inflation measures is leaving the central banks vulnerable to a negative shock that could drive inflation expectations even lower with all the attendant risks of falling inflation becoming more embedded.
And that, in a nutshell, more than any other single factor perhaps, is driving what we believe is for now only a tactical pause at the March meeting in two-weeks’ time. The classic risk management calculation in the higher cost to reverse an outcome, however low its probability, will shape the March meeting policy discussions, and a caution to wait for what will hopefully be greater clarity on the outlook both at home and abroad, by late spring and perhaps in time for the June meeting.