Fed: Affirming Sooner and Slower

Published on November 20, 2015

Wednesday’s Minutes to the Federal Open Market Committee’s October meeting were largely as expected – no surprise a Committee majority would really like to start policy normalization next month – and we would take the price action since as a clear green light to get on with it.

Indeed, judging by the market’s repositioning, it would have to be said the decision in the “close call” September meeting to hold off on a rate hike is looking rather vindicated in an almost exact replication of the success in the stumbled, two-step launch of the taper exactly two years ago. A brief hit to credibility notwithstanding, points to the Fed on this one.

Going forward from the Minutes and with an eye to the FOMC’s December 15-16 meeting, a few takeaways stand out for us:

*** The Fed’s current estimates of a barely positive effective equilibrium real interest rate, which was the subject of a staff-prepared discussion in the October meeting, underscores why the FOMC is so confident the rate trajectory is likely to be gradual and shallow. It likewise points to a December Summary of Economic Projections rate dot matrix that is likely to show the upper range of the 2016 dots being marked down sharply to converge towards a tighter median between three and four rate hikes, and a longer run neutral rate slipping further below 3.5%. ***

*** For all its crossed signals in the past, the quarterly blue dot rate plots may finally come into their own with a first rate hike out of the way. The FOMC is likely to shy away from inserting a more explicit “gradual” forward guidance in the December statement — with the market still pricing under a lowered Fed dot plot, it can be saved for later if needed — instead relying primarily on the lowered range and median of the rate dot projections across the three-year forecasting horizon to telegraph the expected gradual and shallow trajectory. ***

*** But the real test to “sooner and slower” will come in whether, when, or at what pace inflation turns upward. Strong dollar and weak oil price base effects should fade out of the data through next year to bump goods inflation higher, while a tight labor market is expected to exert a slower but steady upward pressure on services inflation. But the uncertainty in that inflation dynamic is why the FOMC needs maximum policy flexibility to potentially move rates more quickly or slower still. ***

In other words, the still to be defined hurdle to the second rate hike is likely to prove as or more important as that “sooner” start to policy normalization with a December first rate hike in shaping the pace of the long, gradual rate trajectory the Fed badly wants, in order to minimize the risk of policy error along the way.

A Slowly Rising Equilibrium Interest Rate

A gradual and shallow rate path has, of course, been a steady mantra of nearly all the FOMC members for some time, and that this optimal rate path needs to start “sooner” than what might be indicated in the cold light of the data has long been a cornerstone to Chair Janet Yellen’s policy framework, and which we have been highlighting since last spring (see SGH 3/27/15, “Fed: The Emerging Policy Path”).

Through most of this year deeply skeptical markets have been hardened against the Fed’s “each meeting is live” communications by repeated false dawns, all too frequent, somewhat mixed messaging by Fed officials, or by a confusing silence from the Chair in the crucial run up to the September meeting.

But that has all changed in the wake of October statement’s dip back into an explicit signal about “the next meeting.” A far stronger than expected Non-Farm Payrolls print soon followed, reinforced throughout the recent weeks by a surprising consistency in the public remarks by Committee members.

And if there were any remaining doubts about the FOMC’s intentions in three weeks’ time, the October meeting Minutes released this week were written as though to drive home the sooner and slower path, with all the reasons and thinking behind it threaded throughout the Minutes from beginning to end.

The Minutes opened, for instance, with the Committee discussion of the staff-prepared study updating the latest estimates on the equilibrium real interest rate. The importance of those estimates to the policy framework was laid out by Chair Yellen in her San Francisco speech in March this year. In it, she distinguished between the longer run equilibrium rate represented in the longer run neutral rate charted in the SEP dot plot, and a near term effective equilibrium real interest rate that is variable rather than fixed as in a Taylor Rule or as seems to be assumed in most secular stagnation arguments.

The most recent staff updates to the estimates found that equilibrium rate to be barely positive if not zero. It means monetary policy has not been as simulative as could be assumed with 0-25 basis point policy rate and after several years of large-scale asset purchases and “lower for longer” forward policy guidance. It likewise means the policy rate should only be lifted as gradually as that effective equilibrium rate is rising, as the cyclical headwinds in the aftermath of the financial crisis dissipate; and above all, it makes it imperative for the Fed to raise its policy rate carefully and cautiously for fear of a policy error in moving too far ahead and causing the recovery to stall.

This slowly rising effective equilibrium rate provides the conceptual underpinning to the various arguments laid out by Committee members later in the Minutes on the merits of a sooner and slower rate path: a delay in policy firming could elevate uncertainty in the markets or undermine the central bank credibility, it could stoke financial imbalances, or signal a lack of confidence in what have otherwise been steady, cumulative gains in job creation and aggregate demand, and it could magnify the importance of the first rate hike over the more powerful impact of its pace.

There was some lip service paid to the dovish concerns over the effects of a more persistent than expected strength in the dollar or uncertainty whether the recent slower pace in job creation signaled a slippage back to subpar growth. But there was nothing in the Minutes this time that compared to the relatively robust dovish arguments that were made in the July meeting that in many ways paralleled October’s step towards a first rate hike.

The dovish minority, judging by the tone of the Minutes and our sense of where the Committee consensus is heading, have essentially ceded ground on the first rate hike to build their case for caution around the statement language and the case to be made for a high hurdle to the second rate hike (see SGH 11/12/15, “Fed: The Shifting Debate”).

A “Reasonable Confidence” in Inflation Forecast

To clear the way to a December start to policy normalization, the Committee majority curiously seemed to find its needed “reasonable confidence” for rising core inflation by cherry picking the inflation measures that fit the bill. Yes, low core inflation has persisted for God knows how many months and years in the more traditional inflation measures, but if one looks hard enough in the trimmed mean PCE and CPI measures, there are the desired signs of a modest turn upward.

But perhaps the real point is that the reasonable confidence in the turn towards a more mandate-consistent level of inflation was always based on the forecast, not the data-dependence so exhaustively messaged since March this year.

And for all the debate over the mystery of the inflation process or the merits of the Phillips Curve, the Fed’s base case view remains a more sustained, fundamental underpinning to slowly rising inflation in the upward pressures of a tight labor market on services prices, period.

The Phillips Curve linkages between employment and inflation that were flattened in recent years will be steepening the further we get into a recovery “running hot” at or near full employment. The upward pressure on prices has been restrained up to now in the inflation measures by the very powerful but transitory downward pressures on goods inflation in the strong dollar and the collapse in oil and commodity prices.

By definition, the latter will eventually drop out of the data, the only question is when.

But when they do, as inflation measures are slowly rising with persistent upward pressure on services inflation, the Yellen-led FOMC majority want to already be off from the zero lower bound, with rates closer to 1% than zero, and with all the potential operational difficulties in raising the policy rate well out of the way.

Messaging a Gradual Path with Dots

That brings the Fed and the markets back to the sooner and slower policy path, leaving only how to signal the intent and its probabilities alongside a first rate hike. Indeed, the Minutes singled out “the importance of underscoring this view at the time of liftoff.”

For the minority doves, the optimal statement would include an explicit reference to how high the hurdle to a second rate hike is likely to be, or at least how slowly paced the FOMC expects the subsequent rates hikes to be, perhaps by inserting the word “gradual” into a clause at the end of the sentence affirming a 25bp rise in the target fed funds range.

But, though bearing in mind the December meeting is still some three weeks away that already seems unlikely, for three reasons. For one, despite the brief dalliance with a return to explicit signaling in the October statement, it was intended as a singular effort to jolt the market’s attention to the high likelihood of a rate hike at the next meeting. It was not meant to mark a retreat back to forward guidance.

Somewhat more obviously, it is not necessarily needed in the near term, as the market is still pricing under the Fed’s own rate trajectory, even if it is lowered in the December dots matrix; and for another, there is some thinking it is better in any case to save the affirmation of a gradual pace into the statement for later if ever the market should get a little too antsy and start pricing in an excessive tightening in financial conditions.

Taken together, it points to a building consensus among a Committee majority to rely on the much maligned blue dot rate plots of the quarterly SEPs to do the heavy lifting as the rate guidance from here. Several Committee members have already gone out of their way to stress the value of the range and median of the dots in providing the base case path and the parameters of the Fed’s reaction function to data that comes in to the south or north of the central tendency.

And if the Committee is hoping the updated dot matrix will do most of the heavy lifting to convey the sort of “dovish hike” envisioned in September, they are more than likely to get just that kind of result in December, and then some.

With almost the entire Committee having penciled in more than one hike in their September dot plots, for instance, it means almost by definition, we are likely to see the immediate year 2016 dots lurching down in a convergence near 1%. Who knows where the 2017 dots will settle, other than lower, but 2018 is likely to see a tighter convergence a bit below a longer run neutral rate that is also likely to be nudged lower by all but a few members to under 3.5%.

The reality of a first rate hike, as opposed to plotting projections for the appropriate policy rate in a forecast, will in effect transform the way both the Committee and the markets look at the dot matrix. They will now become more real, at least next year.

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