Fed: Beyond October

Published on October 18, 2013

That there is little to no chance for a taper at the Federal Open Market Committee’s October 30-31 meeting is hardly a daring observation to make. It would be a real Halloween shocker if they did. The important thing about the October meeting is going to be the FOMC’s discussions over its messaging strategy and trying to get a handle on the outlook.

The fact is, as close as the decision may have been in September, there doesn’t seem to be a consensus on the taper going into this meeting, when to start, or even what exactly will be the criteria to start. In that sense, the government shutdown and the loss of data for a while provides a convenient cover to take a pass on that decision.

*** So to get the taper question out of the way, for now, the start to winding down the $85 billion a month in open ended bond buying could come as early as the December meeting or as late as the March meeting. On balance, a first taper does seem more likely after the turn of the year. But whenever the start, we do think the great wind down in QE is more likely than not to be a fairly rapid descent in three steps at most, with the aim still to bring QE to a close some time in the middle of next year. ***

*** In the meantime, the interval on the taper debate is going to be aggressively used to bolster a widely held consensus to message the need for continued accommodation for years to come. That will entail what we referred to in an earlier report (SGH  10/1/13, “Fed: Forward Guidance, Fiscal Retrenchment, and the Taper”) as a “re-set” to reaffirm and reinforce the lower for longer forward guidance on rates and the gradual ascent in rates once the tightening is underway. And an FOMC majority likewise believes the total stock of the open ended program will be around $1.2 trillion and maybe more, depending on the progress of the economy through the winter. ***

Guidance Re-Set and Reinforcement

In the coming months, we think a majority of the FOMC members will continue with a theme common to the early round of post September meeting speeches, namely, a version of what former New York Fed President Gerry Corrigan used to call “constructive ambiguity.”

By that we mean with the start to the taper so uncertain, most of the FOMC will try to change the subject as much as they can, from the “will they or won’t they soon start the taper” to putting their messaging accent on how long this overall accommodation is going to stay in place, and blurring the distinction between whether that ample accommodation will come from QE or the low rates, or both.

Nearly all the members of that very diverse FOMC believe the economy needs plentiful accommodation for some time to come. Most of the FOMC speeches since the September meeting have already played on that theme and they are likely to continue doing so until a clear picture on the outlook emerges and a consensus forms within the committee.

That will translate into a repeated messaging on the “lower for longer” rates guidance, and the equally important “slower for longer” trajectory of the rates once the tightening is underway. That Vice Chair Janet Yellen is the presumed next Chair will give particular weight to this “optimal policy path” that she was the first to articulate in several earlier influential speeches.

That message will be underscored in two ways in the near term. First by reference to the year-end fed funds rate projections of the September Summary of Economic Projections that put the cluster of “dots” in 2015 at just under 1% and the cluster in 2016 at barely 2%.

That trajectory puts projected fed funds at barely half the assumed neutral level of the fed funds rate with both unemployment and inflation both projected to be finally back to trend in 2016 and real GDP growth already above trend and dipping that year to a central tendency range of back a bit to 2.5% to 3.3% from 3% to 3.5% in 2015.

A Lower Neutral

And along those lines, one theme that is likely to be repeated in the coming weeks is a growing belief within the Fed that due to lingering headwinds, it will in fact take several more years before neutral will be at the assumed 4% level of the projections; that is, there are further underlying economic reason for such an “optimal policy path” of a gradual tightening trajectory as well as the Fed’s state-contingent policy intentions to keep rates low.

The lower for longer rates guidance could be further reinforced as early as the December meeting, but probably at some point in the first quarter next year if needed, with the adjustments to the inflation and unemployment thresholds.

A lower 1.5% band to the 2.5% safeguard inflation threshold has already been widely discussed and seems to be winning more support as the inflation rates persist at such low levels. That lower band to the inflation threshold could be introduced as soon as deemed necessary to reinforce that rates simply will not be increased if inflation remains below 1.5%.

Likewise, the FOMC has been discussing since June a potential adjustment in the 6.5% unemployment threshold to as low as 5.5%-5.75%. The latter, however, is proving to be more difficult than the former. There is the whole ongoing debate over the labor participation rate and the other labor market indicators Vice Chair Yellen laid out earlier this year.

An outright change in the threshold rather than adding to them is causing considerable hesitation over undermining the credibility of the entire threshold framework. So for now it seems more likely the accent will be on the threshold not a trigger distinction.

High Noise/Low Signal Data

In the meantime, while the Fed presses home on its rate guidance as the mainstay policy instrument, it will be scrutinizing the data for clearer indications the economy is finally showing the sustained but so far elusive take-off that would make it easier to begin reducing the pace of the additional accommodation being pumped into financial conditions with the $85 billion a month in bond buying.

When they start, or by how much, or what the likely mix is going to be between treasuries and MBS are all decisions that are to some extent on the back burner. As we noted earlier, the shutdown and the absence of data as well as the likely high noise/low signal value of the data over the next few weeks in some ways provides the FOMC some cover to push the taper debate a bit to the back burner.

December does seem a lower probability unless the inevitably noisy data before then unmistakably points to a firming recovery. In making October a “live” meeting — the Chairman could potentially announce a post-meeting presser — it also makes January an equally live meeting. And of course, the March meeting will be presumed next Chair Janet Yellen’s first, although her influence will be steadily rising long before her first meeting at the helm.

Above all, a larger, looming driver to the taper decision is in fact less about it being data-driven as much as it is a high degree of confidence that when it does come, it will not trigger a surge again in yields that came in the premature signals of the summer.

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