Fed: Cautiously Repositioning

Published on August 27, 2015

Federal Reserve Bank of New York President Bill Dudley yesterday morning offered a surprisingly candid assessment of the current state of the Federal Open Market Committee consensus on a first rate hike at the September meeting, namely, that it is not especially certain.

And Esther George, the ever reliably hawkish Kansas City Fed President and host to the Jackson Hole conference that opens with cocktails in a few hours, conceded this morning that caution is indeed warranted to assess potential changes to the outlook, even if she still leans to a September rate hike.

*** Market volatility and the uncertainty it creates over the near term outlook, and in particular, a potential new downdraft of global disinflationary pressures, has indeed shifted the burden of proof within the Committee against a September first rate hike. A solid FOMC majority, however, remains firmly behind the “sooner” argument to start policy normalization before year-end, and if not September, to make October more of a “live” meeting with a press conference and to neutralize the illiquidity obstacles to December. ***

*** And however “less compelling” September may be, most FOMC members still want the door left ajar to move next month, especially if markets continue to settle and the growth outlook emerges relatively unscathed. There is some concern that data are unlikely to be much clearer or more compelling through the rest of the year, and there is a nagging concern the longer the FOMC waits, the more difficult it may prove to raise rates, with an ever larger market volatility to scale, and the benefits of a “sooner and gradual” policy normalization slipping away. ***

*** With time running out, further Fed messaging beyond the dovish imprint now stamped on market expectations will come at Jackson Hole. We expect the takeaways from Vice Chair Stanley Fischer’s scheduled remarks on Saturday and Fed officials speaking on the sidelines to entail a tricky juggling act to calm market jitters while discounting their importance to policy timing, and carving out more time to assess the data that keeps a September first rate hike on the table or at minimum steers expectations to a newly live October meeting. ***

A “Less Compelling” September

By any account, New York Fed President Dudley’s carefully worded “less compelling” steer — bolted onto a planned speech on the regional economy — all but confirmed the already dovish market expectations a September rate hike is not especially likely at this point. (He was less convincing, though, in his assertion the recent market volatility was “not about us” when the markets worldwide so quickly rallied and settled down, for a while at least, after his remarks were taken as meaning a September rate hike is off the table.)

Dudley even went so far as to neuter the August Non-Farm Payroll numbers slated for release on September 4, noting it will be “stale” since its surveys came the week before the market mayhem. And he also offered a nod to the University of Michigan consumer confidence surveys — the final for August is tomorrow and the September preliminary survey is September 11 – as early warning indicators of any recoil in consumer spending as a stock market turmoil aftershock.

We will be curious if his framing of how to react to the upcoming data points will be shared by other Committee members, as his discounting of the NFP, for instance, means the market is likely to double down on dovish pricing if it is weaker than expectations, while capping any upside re-pricing on what is likely to be a print marking a still reasonably healthy pace of job creation.

But more than anything, his remarks yesterday certainly underscores the new sense of wary caution in the Committee’s risk/reward calculations as it nears a start to its long sought policy normalization.

And that is the note Kansas City President George played in her tune on the policy outlook in multiple press interviews earlier this morning: take caution in the sentiments so soon after such a steep market swoon, as time will be needed to weigh the uncertainties over China and global growth, the inflation outlook, as well as to look for any lingering impact of the market dislocations on US confidence and spending.

Outlook Revisions and China

Indeed, market anxieties twisted around by the volatility notwithstanding, the Fed Board and District staff work on the forecast projections being prepared for the September meeting will be methodically reworking new assumptions for the growth outlook, and which may in the end only be marginally affected by the events of the last few weeks.

The chipping away in stock market wealth — and that assumes a lower stock market is sustained over an extended period – or the loss in export gains due to a still rising dollar, for instance, may be more than offset by the renewed decline in gasoline prices and especially by the drop in risk-free yields even if credit spreads have widened.

By the time the Summary of Economic Projections for real growth and employment gains are laid out at the September meeting, our sense is that they may only show a marginal drift lower than the June forecasts at most, and essentially still lie inside the baseline path that was driving the majority of the Committee to weigh that first rate hike.

The impact of China, however, could be a different story and probably remains more of a wildcard than the market volatility.  The Fed tends to shy away from singling out a country in its drafting of the Minutes, but a watchful eye over China’s growth and its impact on other Emerging Market countries dependent on commodity exports to China has been at the forefront of the Fed’s concerns for some time, and certainly long before Beijing’s August 11 devaluation of the Renminbi in its change of the currency regime.

Perhaps the most noteworthy risk in China’s adjustments to maintain domestic growth lies in another disinflationary impulse pulling down tradeable goods prices that could stall or wash out the “fade” in the effects of the strong dollar expected for some time next year. That could then push the expected rise in core inflation next year, when stronger wage growth is expected to be lifting services inflation, ever further out the forecasting horizon.

The precise timing of when this all could be working its way into second round effects in US domestic pricing is not well understood, but it could prove hard to argue the softness in inflation is going away any time soon. And that, in turn, could and probably is undermining “many” of the Committee members’ “reasonable confidence” that inflation will be rising soon on the back of steady albeit unspectacular jobs growth.

The “Sooner” Consensus Still Intact

As late as the July meeting as evidenced in the Minutes, however, a voting majority of the Committee were nevertheless still betting those disinflationary impulses will be “transitory,” that the dollar’s rise may be somewhat limited by how far it has already moved higher, for instance, while the impact on headline inflation in lower oil and energy costs is likely to fade over time. Just as the Fed looked through the rise in oil and energy prices years ago, it would be only consistent to do the same to look through the dramatic freefall in oil prices, even if it lasts for years. 

And for all the doubts over the merits of a slack-based Phillips Curve view of the economy, it remains a core conceptual framework to the current policy path, and as night follows day, as long as the laws of supply and demand still apply, inflation will begin to rise as labor market slack is slowly removed on the back of steady job creation in an economy running hot for long enough that it may even nudge up a broad-based waged growth.

Likewise, the “sooner” thesis — that moving on rates before there is firmer evidence in wage or price measures maximizes the policy flexibility to pace subsequent rate hikes as gradually as possible to avoid rapid rate hikes that derail the recovery or crater the financial markets — firmly remains a compelling argument for a Committee majority to press ahead with a start to policy normalization in one of the three remaining meetings before year-end.

For that Committee majority, the adjustments to changes in the forecast can come, not in further delays to the start to policy normalization this year, but in the subsequent pace of rate hikes. There is certainly unlikely to be but one rate hike before year-end, with a second probably pushed back to perhaps next March.

Making All Meetings Truly Live

All else being equal that makes the assessment of the data and where it is pointing to any tweaks to the growth and inflation projections in essence a tactical question on the ideal meeting to make that judgement call on when to pull the trigger on a first rate hike.

Our sense, then, is that if the clock is run down to rule out a September first rate as seems more likely than not now, the FOMC is already weighing whether to move to make October more of a live meeting. That essentially means announcing there will be a press conference to follow the meeting and statement.

The announcement effect alone would be likely to boost market pricing expectations, so the sooner it comes the better if that is indeed the path taken, especially if high odds for October were carefully staged managed in the September statement and press conference. And more time to message a reset to policy intentions — and to more or less pray that the data adheres without surprises to the central tendency forecast without downside shocks — would likewise help lessen the risks to a first rate hike as late as the December meeting amid highly illiquid markets if the markets are well prepared and the Fed messaging is taken seriously this time.

So even while September may now be less compelling, just how much a majority of the Committee still want to press ahead with a first rate hike before year-end should not be underestimated. Nor should the FOMC’s willingness to push through a market storm, as they have long indicated there is likely to be considerable debris on the road in their rearview mirror when they do hike. Well on that, we will soon see anyway.

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