Fed: Calibrating the Guidance for Lift-off

Published on July 24, 2014

We have been saying since we can remember (well, early spring anyway, SGH 4/22/14, “Fed: Twists and Turns” comes to mind) that the Federal Open Market Committee’s September meeting is likely to be one of the most important this year. We still think that will be the case, even more so, on a number of fronts. That will also provide a good way to frame expectations for next week’s FOMC statement.

*** The July statement is likely to affirm the economy is doing better than expected, despite the oddball first quarter data. The FOMC is equally likely, however, to stop short of major changes to the guidance. But its brighter tone should be seen as building on the ever so slight hawkish nuance (admittedly, perhaps too nuanced) in Chair Janet Yellen’s Humphrey Hawkins testimony last week; taken together, these two tonal shifts are meant to give the Committee the option — if the data doesn’t disappoint — to more explicitly tweak the forward guidance in September to reflect a modest upward tilt in the balance of risks into year-end. ***

*** For all the FOMC debate across an already crowded September agenda — the next blue dot rate projections, including the 2017 rates, the revised sequencing to the Exit, the end to the taper, and how to adjust the guidance — our sense is that hawks and doves are in fact moving closer in their views than commonly assumed. With the anxieties over low inflation increasingly in the rear view mirror, doves in particular are becoming more comfortable with the approaching rates hikes. Indeed, much of the debate to at least December will revolve around when and how to steer the guidance in probable multiple steps to best position the Fed for a timeline to the first rate tightening trajectory in eleven years. ***

*** Barring a reversal in the data and despite the still quite dovish leanings of the FOMC — and the very dovish market pricing — we now increasingly believe the timeline coming into view as early as September and probably taking a more distinct shape by December is more likely than not to point to a first rate hike in June 2015. ***

An Evolving Guidance

Though September is to us the pivotal meeting to watch, two quick points are worth noting about the FOMC meeting and statement next week. First, much of the two days is going to be taken up working out the finer details to the revisions to the June 2011 Exit Principles. We do not expect the FOMC to finish the work next week, but at the September meeting.

The FOMC has been quite keen to have the new sequencing agreed to before the tapering of the bond purchases draws to a close in October, so we do expect the new Exit Principles to be announced then, perhaps as an attachment to the statement and providing Chair Yellen the opportunity to explain them more fully in the post-meeting presser.

Second, and more to the theme we are addressing in this report, the FOMC will invariably have to acknowledge the better looking state of the labor markets and the general improvement in the economic outlook. A 6.1% unemployment rate, even if there still remains labor market slack due to the still high though falling percentage of longer term unemployed or part time workers seeking full time work, it would nevertheless defy credibility not to note in the opening paragraphs of the July statement there have been improvements across nearly all parts of the economy since the June meeting.

Things are obviously short of being peachy — weakish consumer spending, ongoing repair to balance sheet wealth, and still somewhat tight access to mortgage credit, all remain points of caution – but our sense is that the majority of the Committee is nevertheless feeling increasingly more confident the ever elusive escape velocity to a self-sustaining recovery is within sight. Geopolitical uncertainty may loom on the horizon — it would be interesting it if garners a note in the statement — but there is a view across the system that post- first quarter growth remains on a near 3% pace, and that even if does falter a bit this year, it will hit the mark next year, or at least still maintain a pace just north of trend growth to keep generating job growth. This morning’s low jobs claims number would seem to further validate the sense of confidence.

The key phrasing of the forward guidance, however, is unlikely to be tweaked in any meaningful way, simply because it is still just a tad too early to do so. Instead, September remains the first real opportunity for the Committee to assess how close they are to achieving their twin mandates on employment and inflation.

But — and this is a crucial but — we believe any tweaks towards a brighter take on the outlook in the July statement would be building on an intended, albeit ever so slight, change taken by Chair Yellen in her careful phrasing on the uncertainty in the forecasts and the Fed’s policy path when she testified last week on Capitol Hill.

In stressing the balanced approach the Fed will take, she highlighted scenarios under which the Fed could either push rate hikes back or bring them forward, even quickening their pace, depending on the evolution of the data and the forecasts. In the past she has tended to put this in a more declarative form, but she did so this time prefacing the two scenarios by noting the continued improvements in the labor market already taking place, implying that of the two scenarios presented, the odds are starting to favor the former over the latter.

Chair Yellen in effect wrote a free option on the Fed messaging to either stay put on the very dovish messaging for a while longer, or take another small step towards tweaks in rhetorical tone and the formal statement guidance to reflect a modest tilt in risks to the upside — if warranted by the forthcoming data and the movement in the FOMC consensus.

We suspect that may especially prove to be the case by the time of the September meeting.

September’s Busy Agenda

The FOMC’s agenda for the September meeting and what will be discussed in the presser is looking pretty full. For one, there are those 2017 blue dot rate projections, which we think will show a solid majority of the Committee’s year-end rates north of 3%, and for another, the new sequencing in the revamp to the June 2011 Exit Principles is likely to be unveiled in September. And of course, the FOMC is likely to affirm the taper of the open ended bond purchases will indeed be brought to a close with the last rump of $15 billion wound down in October.

But the end to the taper does mean that, regardless of what the economy is doing, the Committee will also need to adjust its “considerable time” phrasing in the forward guidance since it ties the lift-off in rates to a taper that the following month no longer exists.

It is a bit early to speculate too much about how the guidance language may change in September — “highly accommodative” policy could change to just “accommodative” policy that is appropriate; the FOMC could acknowledge inflation is no longer running below the 2% longer run target; the steady improvements in the labor market could be more declarative rather than conditional — but at a minimum, the Committee will have to either drop the “considerable time” phrasing altogether or change it to affirming the Fed “can be “patient” on rate hikes, both in the spirit of vague “qualitative” guidance, or by tying it to a different anchor, say, to the end to the reinvestment policies.

On the latter option, for instance, there could be something of a bookend to the December 2013 decision to start the taper in the bond purchases with an offset of a “changing of the mix” towards an even more dovish forward guidance on rates. In this case, one thought is for the Committee to do a near exact mirror reversal of that by pushing off the end to the reinvestments — thus keeping the balance sheet constant — in return for tightening up the rates guidance, and in effect, bringing the timing to the first rate hike forward.

But the more interesting point is that for many Committee members, they may begin to use this moment in fixing the “considerable time” phrasing to press for a more clearly mapped out progression in steadily toning down if not removing at least some of the highly accommodative language from the guidance through the following meetings and December in particular, all depending of course what the data is saying about the pace of the recovery and the revisions to the forecasts on inflation and employment.

The Yellen Consensus

Chair Yellen is determined to ensure an accommodative policy is kept in place for as long as necessary, or possible, to ensure as much repair to the labor market as possible, including a healthier increase in wages to help underpin a more broadly based growth in aggregate demand. Above all, her belief and bet is that inertia in inflationary pressures after such a long period of high unemployment and low wage pressures allows for patience against prematurely tightening rates.

The prize in her virtual rewriting of monetary policy orthodoxy is the prospect of engineering the conditions for a virtuous cycle of an expanding labor force, at least a rise in the total of hours worked if not higher and steadier wage growth, higher business investment spending and worker training that reverses the lost output and labor skills since the 2008 crisis, and indeed, leads to higher productivity and a higher trend growth.

She is playing a long hand in building her monetary policy strategy, and she knows the collegial consensus-based culture of the Fed well, being very careful so far as Chair to pick her battles, putting off debates until they need to be taken up, and sticking to a messaging discipline to keep the Committee aligned and free of dissents for as long as possible.

But at the same time, as we have written before (SGH 4/10/14, “Fed: Deepening the Consensus”), she is hardly an ideological dove, and can be hawkish when needed, it is just that inflation is just not seen as a near term threat, not that it will never matter.

There is, of course, still to come contentious debate over the structurally versus cyclically unemployed, the demographics of the decline in the labor participation rate and whether or to what extent it will at least stabilize, and there remains considerable dispute over the role of wages in the early stages of the inflationary process.

But more to the point, it is surprising how much most of the FOMC embraces where she is steering the Committee consensus on the endgame to the current policy path. Hawks are not as hawkish it seems, but equally, the doves are not as dovish as reputations suggest, certainly when the Fed is coming that much closer to achieving its twin mandates on employment and inflation.

There has been considerable convergence in recent months, for instance, on the merits of monitoring wage growth and average hourly earnings, or the hires/quit rates as more useful measures of labor market slack, or to keep a close eye on the index of total hours worked as a better way to track the movement between part and full time workers. The recent Board research confirming that the longer term unemployed are indeed returning to the labor force was seen as a validation of Yellen’s bet on labor market slack beyond the headline unemployment.

Many if not most Committee members are likewise barely registering concern over the recent modest uptick in inflation, seeing little to no signs of it accelerating any time soon; they are for the most part more relieved than stressed because the uptick suggests the unexpected persistence in low inflation is fading from sight (SGH 7/1/14, “Fed: Will Yellen do a Carney?”). This is important, especially among the more dovishly-inclined, for it allows them to think more clearly in terms of rate increases that they previously feared could press inflation expectations down and risk the sort of deflation suffered by Japan for two decades and currently being faced down in Europe.

Instead, our sense is that the differences within the Committee on the debates through this fall are more likely to be about degree than direction. The hesitation of a few Committee members is less about near term inflation risk, or a reluctance to probe where Nairu — that they are perfectly willing to do; the concern is instead more specific, that the Fed, after all the work to get to this point, could be caught flat footed with a guidance that is simply too dovish relative to a recovery looking increasingly like it is finally on a self-sustaining trajectory.

“Bayesian Moment”

At some point, potentially as early as the crowded September meeting, maybe October, but probably no later than December, the FOMC debates will reach a “Bayesian Moment” when the policy calculation will invariably balance on weighing the risks if the policy path proves to be wrong and the costs in repairing the damage done if, say, inflation surprises to the upside — in either the real economy or in asset prices — looks to outweigh the rewards of hitting the sweet spot of full employment, rising productivity and a rising trend growth.

So as a safeguard, the argument  that will begin to take centerstage as soon as the September meeting and continue right through at least a potentially pivotal December meeting is whether and to what extent the Committee should begin calibrating the forward policy guidance in order to better position the Fed if the data wrongfoots the Fed’s expectations. The risk then is the Fed could lose credibility with the market at just the wrong time, forcing it to raise rates more quickly than desired.  

That would not only put the recovery at risk but heighten the risks of financial market dislocation, which if truth be told, is the far greater threat to the Fed than goods and services inflation in the next few years. And that could be too high a possible price even for the most ardently dovish Committee members.

How that Bayesian moment plays out and where it puts the Committee consensus will define the adjustments to the guidance, and exact timeline to the first rate hike. It seems more likely and is indeed preferred by most of the FOMC for the truly significant change in the guidance to come in steps, but perhaps by the December statement for there to be clearly phrased forward guidance indicating that a countdown to a rate hike is underway.

The template to laying out such a timeline in multiple steps is the run up to the last time the FOMC started a rate tightening cycle, in June 2004 — some eleven years ago! Those hikes were signaled through minor language changes in the December 2003 statement building in stages to a May statement that affirmed coming rate hikes are “likely to be measured” just before the first 25 basis point hike in June.

Again, we suspect that lift-off is looking more likely to be brought forward to June next year, which we think is for now about the earliest for consensus on the FOMC to pencil in a tightening unless they and most everyone is utterly wrong on how quickly the economy is recovering. Likewise the odds are tailing off for a first rate hike in the fall or later than September next year, unless the economy turns seriously south in the next half-year or so ahead.

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