Fed: December and When To Pause

Published on December 10, 2018

With nothing to suggest the Federal Open Market Committee is backing away from its well telegraphed intentions to raise interest rates at its meeting next week, the question is whether the Fed will also bring the year to a close with an explicit signaling that the central bank is indeed nearing the end of its two year rate tightening cycle.

*** We do still think a pause of at least two or more meetings is likely next year, perhaps beyond January as soon as March (SGH 11/16/18, “Fed: A Premium on Policy Flexibility”). The probability of that pause is more likely than not to be evident in what we think could be a modest downward movement in the rate projections across the forecasting horizon that, on balance, should be enough to bring the median rate dot projections down from three to two hikes in 2019. But we doubt there will be an explicit signaling of certainty to a rate pause, much less nearing an end to further rate increases in either the statement or in Chairman Powell’s remarks to the press. ***

*** Our sense is that there remains too much of a wide variance around the base case rate path next year to do so in light of the uncertainty over fiscal and trade policies, Brexit repercussions or slowing global growth, and the ongoing internal differences in views on the evolution in inflation and productivity. Trend growth may be marked up by some Committee members, for instance, while others mark longer run unemployment down, with neither probably enough to move the needle on the respective median projections. The likely removal of the “further gradual” phrasing in the statement will be meant to underscore that outlook uncertainty. ***

*** The December rate increase will also effectively mark the successful end to the policy normalization narrative set in motion by former Chair Janet Yellen two years ago and exactly ten years since the Fed first dropped the policy rate to the Zero Lower Bound. But Chairman Powell has still to fully flesh out a new “normalized” policy story line beyond a “data dependent” path and the need for maximum policy discretion. The market volatility amid the somewhat muddled messaging over neutral in the previous months could mean a higher degree of scrutiny next week and the end to his honeymoon of sorts as Chairman. ***

A Gentler NFP and Softer Inflation

In some ways, the need for the Chairman to flesh out a a richer, fuller policy narrative was made a little bit easier by the gentle changes in labor market trends suggested by last Friday’s Non-Farm Payrolls.

The mix of the headline numbers and the breakdown of its composition neatly underlined the Fed messaging that is likely to take shape next week: a still solid job creation above the levels needed to cool the economy, but a pace slowing enough to allow for a less hawkish near term policy stance, and an Average Hourly Earnings that was likewise still modestly picking up, though still far from accelerating or signaling any sort of sustained upward cost pressures.

There is nothing in the labor market data, in other words, nor the recent data in general, that points to a worrisome or significant slowing in growth beyond what is already baked into the forecasts.

Indeed, the labor market by years-end neatly aligns with the near certain December increase in the target fed funds range to 2.25%-2.5% — which is equally likely to include a technical increase in the Interest on Excess Reserves to 2.40% — that will safely put the policy rate into the bottom end of that “broad range of estimates” for neutral so carefully cited by Chairman Powell a few weeks ago.

Along the same lines, the modest softening across the various inflation measures in the last few months would seem to likewise point to the modestly less hawkish policy stance going into next year.

But we would caution that the lower inflation prints are still within the confidence bands of a presumed still steady, upward pressure on inflation that will be breaching the 2% inflation target at some point next year, and there are still enough Committee members uneasy over too firm of a near-certain messaging on the probabilities for a pause in the rate path next year. There is, after all, still likely to be an upward sloping trajectory in the rate dot plot of the December Summary of Economic Projections.

The Committee consensus is thus nowhere near presuming an end to the rate tightening cycle altogether. If for any other reason, until the data provides a clearer signal of the economy’s underlying trend, signaling a near end to the rate tightening would in any case run against the entire arc of their efforts to strip out the last of the formal guidance in the statement.

Evolution of Inflation Remains Key

That said, even if a renewed persistently low inflation is a low probability next year, it would still be  the most feared outcome. So from the Bayesian risk management approach being adopted by Powell, it is we think going to be enough, on the margin, to nudge the Committee towards some degree of willingness to consider the merits of a pause next year, data permitting, as soon as the March meeting.

And while we do not think he was speaking on behalf of a Committee consensus, or necessarily for the Chairman, Vice Chairman Richard Clarida probably also had that Bayesian risk in mind when he recently mentioned his concerns for inflation that remains too low as well as running too high.

Very much along the same lines, and lending support to the Committee discussions on the merits of a pause at some point next year, we also find it noteworthy there may be a modest change in the forecast for inflation across the three year forecasting horizon that will become evident in the December SEPs and rate dot projections.

While there is a solid majority of the Committee still adhering to some form of Phillips Curve expectations, the staff majority view, we suspect, holds to a broad view that the recent mild softening in inflation is more or less in line with its inertial trend line ever since the onset of the Financial Crisis, if not before and throughout the period of the so-called Great Moderation.

The Phillips Curve, then, though still assumed to be steepening from its flat line of the last decade or more, may not be exerting as much upward pressure as previously factored into the forecasts as recently as the September Summary of Economic Projections. And that, we suspect, may translate into a slightly flatter, however still upward sloping, median of rate projections going into 2021.

It should be more than enough to elongate the rate plots across the forecasting horizon of the SEPs, and working backwards from there, we think it may be enough to tug down the median number of rate hikes in either 2019 or 2020, with decent odds the median falls to two hikes from three next year.

That evolution in the views on the inflation process may in fact have had a lot to do with the movement by Chairman Powell from his unscripted “a long way” from neutral in early October that to his “just under” neutral phrasing in late November; the “probably” he added almost as a quick afterthought in October was perhaps the missing link to the “broad estimates of neutral” carefully put into the November messaging.

Messaging Fine Tuning

If the median dots do drop to two, but the market is still barely pricing a single rate hike in 2019, Chairman Powell might put the accent on the uncertainty over inflation or the potential for a boost to demand in another fiscal reflation in order to get more upside risk into expectations.

And if the 2019 dot plots somehow do stay at three, we suspect Chairman Powell will scramble to put a bit more accent on the merits of a pause next year to assess the lagged effects in the accumulative rate hikes to date. In either of those balancing acts to match the rate dots, the statement, and the tone to his press remarks, Powell’s intended takeaway will be the need for maximum policy discretion that the markets price accordingly.

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