Fed: Defining Gradual

Published on December 9, 2015

It is a testimony to the apparent success of the Federal Reserve’s policy messaging in recent weeks that not only does the near certainty of a first rate increase next week already seem anti-climactic, but the focus of the market has already shifted to the pace of the rate hikes that will follow.

With the Federal Open Market Committee’s December meeting statement exactly a week away, several points of consensus are coming into a sharper view:

*** The FOMC will frame next week’s 25 basis point rate increase as a “dovish hike.” A rate hike at every other meeting is presumably still the base case “gradual” rate path, but we think a cautious approach to the signal-laden second rate hike is likely to leave a Committee majority leaning to April rather than March for that next move, and penciling in three rather than four hikes by year-end. Even if core inflation should unexpectedly rise more quickly than expected, the Committee will be highly reluctant to raise rates in back to back meetings. ***

*** Indeed, we suspect the 2016 December year-end blue dot rate projections will show a significant compression around two dot clusters ranging from two hikes to five, with the median slipping closer towards 1.2%. Likewise, underscoring how shallow this rate cycle is expected to be, the estimates for the longer run neutral rate are also likely to fall, in December or possibly by March next year, with some doves nudging their longer run equilibrium interest rate below 3% and even most of the more hawkish weighing in at no more than 3.5%. ***

*** That said, there remains a premium on policy flexibility. Fed forecasters will see the renewed drop in oil prices more as a stimulus to spending than a delay in the expected rise in inflation. They likewise see limits to further dollar appreciation. And with an underlying inflation at around 1.7%, if the economy looks to be running firmly in line with the forecasts, the Committee with some dissents could raise rates in March. That risk is underscored by the more hawkish tilt in the rotation of voting Committee members next year. ***

A Signal-Laden Second Rate Hike

The market however is already currently pricing an extremely dovish rate path next year, with all of two hikes, far lower than the already gradual pace indicated in the FOMC’s September Summary of Economic Projection’s rate dot matrix; while accepting the inevitability of a first hike next week, the current market pricing is for all practical purposes pricing that first hike as something of a policy error, either that it is premature for the lack of any apparent near term inflation or that the lower oil price will continue to delay the expected rise in the inflation measures.

Numerous doves on the Committee share that concern for a policy error. Having conceded on the December timing to a first rate hike, they are addressing their concerns for a premature or excessive tightening by attempting to put as high a hurdle as possible on the timing to a signal-laden second rate hike that will go a long way to indicating just how gradual the rate path is most likely to be.

Specifically, in contrast to the relatively low bar put on the first rate hike in a “reasonable confidence” for a rise in forecasted inflation, they will be making the case next week for clear evidence in the data that core inflation is indeed heading north before hiking a second time. That, in their eyes, should push its timing back to June at the earliest and probably later.

And the market, for its part, is already pricing for the renewed dip in crude prices to deflate any near term price pressures, certainly tempering the Fed’s expectations of base effects of the prior much more dramatic collapse in oil prices falling out of the data through at least the first few months of next year. The absence of a turn towards higher inflation, in turn, would make it hard for the FOMC to seriously weigh a second rate hike as soon as March, and it is a sentiment shared by the more dovish Committee members.

That dovish case will be also bolstered by what is likely to be a fairly significant decline in the rate dots across the three year forecasting horizon of the December Summary of Economic Projections next week.

In September, the median of the 17 rate dots stood at around 1.4% or four rate hikes in 2016. But that also had six Committee members penciling in two or more hikes in 2015. So with the reality of a single 2015 rate hike next week, there are a handful of Committee members who will need to adjust the appropriate policy firming assumed in their 2016 rate projections well to the south of their September’s dots.

We expect there will be a noticeable compression of the dots centering around two clusters, with the more hawkish Committee members penciling in year-end rates for federal funds around four or more rate hikes with the more dovish clustered around three or even just two rate hikes. That would put the median somewhere around 1.3% or a tad lower, but with the center of gravity in the Committee still dovish in their cautious approach to the second rate hike, we would tend to tip the scale towards a three hike consensus in 2016 – all of course forecast and “data dependent.”

Perhaps even more interestingly, all the Fedspeak about an ever lower trend growth and how slow the time-varying effective equilibrium real interest rate will be in moving higher from its current near zero levels points to another nudge down in the dot estimates of the longer run neutral interest rate.

There is a good chance, we think, that more than a handful of dovish Committee members will mark their long run estimates below 3% for the first time, while even some hawks may no longer see the basis for marking their own projections above 3.5%, or not by much. That would pull the median down yet again, to perhaps 3.3% or lower, a far distance from the assumed longer run neutral rate of 4% to 4.5% levels in the first dot presentations in 2012.

A Premium on Policy Flexibility

But our sense of the consensus taking shape is that the FOMC will nevertheless back away from placing much in the way of setting explicit high hurdles to jump before a second or third rate hike.

Now it may prove to be the case that a second rate hike gets pushed deeper into next year, for whatever reason, and we tend to think the lean within the Committee is for a cautious April hike as most likely, barring a hard to ignore upside surprise. But at the same time we suspect the statement itself will steer clear of explicit rate guidance beyond the “below normal” neutral rate sentence in place since March 2014.

Instead, while it may seem somewhat contradictory, the FOMC is putting a premium on maintaining as much flexibility as possible in its policy options across the rate tightening cycle even as it accents how gradual it believes the pace of tightening is likely to be in this cycle. It is a sort of insurance to guard against being caught flat-footed by a faster than expected rise in the underlying, domestic-driven inflation once the more transitory external dollar and oil effects do eventually fall out of the data.

Fed forecasters, for instance, expect the renewed weakness in crude prices, which will further lower home heating oil and gasoline costs, will boost consumer spending and confidence enough to largely offset another hit to the energy sector in terms of growth as well overwhelm some of the softer effects on price measures in its an added boost to the larger non-energy service sector price pressures.

Add to that the always important dollar factor in the policy calculations. While the European Central Bank’s messaging muddle, which triggered a sharp snapback in Euro strength, may have in some sense helped make the Fed’s first rate hike marginally easier, there remains a fair degree of uncertainty over its longer term effects on the dollar and the extent of any imported deflation from Europe.

In a likely scenario across the time frame that takes into account the lag where monetary policy operates, the Fed is expecting enough of a European recovery that will not only support US exports and provide a tailwind to growth (alongside an equally modest fiscal tailwind and the diminishing odds of a Chinese hard landing), but is also more likely than not to dampen a further dis-inflationary rise in the dollar.

So even if the low oil and high dollar effects are extended further into next year, they will in time still be dropping out of the data on inflation, whose underlying domestically-driven rate the Fed estimates to be running at around 1.7%.

Again, lest it be forgotten, the “sooner and slower” thesis that we have written so frequently about (going back to SGH 3/16/15, “Fed: Towards a Rate Path Consensus”) remains a cornerstone to the Yellen-led FOMC’s policy normalization path And the key benefit to moving “sooner” relative to the potential cost in a premature move is the flexibility it allows to adjust rates either more quickly or more slowly as needed, versus waiting too long and being left to face the need to raise rates rapidly if inflation moves higher or faster than expected.

The probabilities of a March second rate move, all else being equal, are lower than April, we believe, but are probably higher than a June second rate move. And more to the point, those odds are certainly higher than the market’s current pricing, and without adjustments or a concerted new Fed messaging, a March rate hike could trigger quite a jolt to the market’s still very long bond positions.

Maybe further down the Fed will need to double down on the gradual message if the market spikes yields in an overreaction to an unexpectedly strong data point; but perhaps more likely, with the market pricing so much lower than what we think will be the even more gradual pace of the Fed’s messaging, the FOMC may at some point need to push back in the other direction by discouraging the market from being too aggressive in taking the Fed at its word.

And one last point:

Much has recently been made of possible dissents to a Committee decision to increase the target for federal funds to 25-50 basis points. We don’t think a dissent or dissents will matter much. We doubt, for instance, that Chicago President Charles Evans will dissent, but if he does, it in fact would probably only help reinforce the “dovish hike” messaging. And if either or more unlikely, both of the Board doves, Lael Brainard or Dan Tarullo dissent, the same outcome applies in that the shock impact of a Board dissent has already been “devalued” to a some extent by their previous dovish “protest” in front of the October meeting.

A December dissent may only become problematic a bit down the road if the Fed finds itself needing to prod the markets towards a less excessively dovish pricing, say, for instance, in a run up to the March meeting if the FOMC is leaning towards a rate hike and the market is resisting. We in fact think the potentially more potent dissent factor will enter into the policy debate around the timing to a second rate hike, and it could come from either or both the dovish side and perhaps more likely from the hawkish end of the Committee.

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