Fed: An Asymmetric Reaction Function

Published on March 27, 2019

With the market already widely anticipating a rate cut as the most likely next near move by the Federal Reserve, the willingness to consider rate cuts recently cited by several Federal Open Market Committee members is all but adding the fuel for the fires of rate cut pricing.

*** We, however, do not really get much sense for a near rate cut. The Committee consensus feels to us to still be one of a ‘cautious patience” on rates — albeit with a sharp eye for downside risk. A very solid Committee majority are content with the current policy stance, however messy the Fed’s recent policy pivot may have been in getting here, waiting to see whether the data over the coming months provides a clearer line on the base case outlook. Barring a downside shock, an extended pause remains the most likely near rate path into the fall months. ***

*** While the bar to a rate move is fairly high for a Committee majority, that said, it still appears to be modestly lower on a cut versus a hike. And more to the point, there is a distinctly asymmetrical reaction function to the data going forward that looks to be firmly built into the rate stance:

— It will take clear evidence of upward momentum in the decomposition of various inflation measures or in inflation expectations to shift the FOMC into a two-step shift towards further rate hikes, first in a hawkish tilt in its messaging and, in turn, a lagged timing to follow through. on the actual rate hike. That scenario is why so many Committee members pushed a rate hike back from this year into 2020 in their March rate dot plot projections;

— If on the other hand, either inflation or inflation expectations are showing any evidence of a sustained ebbing later this year, and crucially, even if growth looks to be slipping south of the downgrades already penciled into the March real growth projections, it would be enough to trigger a sharp and rapid policy response with an aggressive 50 basis points cut and signaling more would be on the table. ***

*** In other words, a Bayesian risk management “insurance” against recession and/or falling inflation, however low their probability, will drive the FOMC’s policy response through much of this year: with a likely inertial inflation as the upside risk, the cost to a premature rate cut is seen as relatively small, and the lagged reaction would be a bonus in perhaps underpinning inflation expectations; but the cost in turning around entrenched lower inflation expectations and the limited policy room once back to the Effective Lower Bound would be daunting, and politically costly. ***

No Policy Error Seen – Yet

The Committee as a whole, does not view the December rate hike as a policy error, and even if a close run thing, any damage is already being offset with the hard shift to dovish messaging and in time, by global growth catching up with the US and narrowing differentials.

Slowing global growth, the fading in the US fiscal stimulus, and ongoing trade uncertainties that are deterring business investment, are still seen as transitory factors slowing activity through the first half of this year, with an assumption for a modestly stronger and still above trend growth by summer.

In addition, the lagged effects of last year’s rate hikes that were contributing to the current growth slowdown have been (hopefully) largely reversed by the “pivot” in creating far easier financial conditions relative to post-October tightened conditions last year.

Another point to note is that, for now, the savagely volatile, dovish market pricing, and the yield curve inversion to date is still being seen as mostly technically driven and not yet setting off downside alarms.

There is, however, a sense in some quarters within the Committee that the Fed policy messaging in the dramatic drop in the rate dot projections in March, as well as some of the more distinctly leaning remarks by some Committee members is fueling too much of the bearish sentiments in the markets, however much an easing of financial conditions is desired.

There could be some retracing of the dovish messaging if the bearish expectations for recession or market volatility look at risk of becoming self-fulfilling.

A More Globally-driven R*

And while the Powell-led FOMC seems intent to gradually move away from too much public emphasis on its estimates of neutral as guidance, a clear majority of the Committee has downgraded at least their short run r* estimates to very near, just below or just above, the current 2.4% effective fed funds rate.

The staff’s lowered global growth projections in March were nearly enough in themselves to push the the FOMC into the dovish policy pivot. But it was the ebbing growth coming atop the growing realization of the policy consequences of just how inertial the inflation dynamics have become that drove what looked on the outside to be such a stark shift in policy.

In some sense, it is not yet a paradigm shift in the policy stance, but there does seem to be a greater awareness of the impact of global shocks and a more globally defined estimate of neutral, rather than purely domestically driven factors, that is bringing down the Fed’s neutral estimates.

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