Fed: Disparate Perspectives

Published on September 26, 2019

Despite the best efforts of a reporter at last week’s Federal Open Market Committee post-meeting press conference, Federal Reserve Chairman Jerome Powell deflected the question whether the Committee had an easing bias, referring instead to “disparate perspectives” across the Committee and sticking to the script of the purposely ambiguous near guidance of a “meeting to meeting” approach going forward.

*** Powell’s dogged determination to stay as vague as possible notwithstanding, we think there is a slight lean within the Committee, at least among its Board-dominant voting members in the sense of an openness to another rate cut before year-end. But the bar is higher than it was in the July and September two step “insurance” reset of the policy rateThat is to say, a third rate cut this year is more possibility than probability, and we think it will take a clear deterioration in the data or a further escalation in downside risks to cross a tipping point to trigger another rate move this year. ***

*** In light of a likely focus on the balance sheet in October, we would put the odds for a rate cut in October at one in three or even one in four right now, but better than even for December if the economy loses momentum, in which case we suspect a 50 bp cut could also be on the table. Indeed we think December will prove the more crucial FOMC meeting. By then, there may be much more clarity on both the intensity of the Trump trade wars and if or to what extent the trade effects in sapping business confidence and investment spending are spilling over into the broader consumer confidence and aggregate demand. ***

*** On that point, our sense is of a wariness across the FOMC that the resilient consumer spending that has held up demand so far this year may not be able to continue offsetting an extended softer business spending or global weakness into next year. If that scenario should make its way into the base outlook by December, more aggressive rate cuts would be less about “insurance” than pulling out the stops to prevent, if not recession, a dangerous stall speed slide in growth that would leave the US especially vulnerable to a downside shock. ***

Low October Odds for a Cut

We think the FOMC will set itself a fairly high bar to an October rate cut for two reasons. The first is simply that it is quite clear from the first round of public comment from a number of FOMC members that, while there is certainly an openness to the need for a rate cut, there is for now not a lot of passion for it.

Reflecting that, not even the more dovish Committee members are expecting the data to substantially weaken in the next four weeks that would make the case for another rate cut easier to explain and defend. The data are in fact still indicating a fairly resilient, albeit entirely consumer-driven growth, and even inflation has been showing signs in recent months of upward momentum back to the 2% target.

To be fair, the two rate cuts of July and September weren’t data-driven either, but were more about a reset of the policy rate back below a cyclically-driven short run r* that the Fed consensus estimate would currently put at no higher than 2.4%, or even lower for some Committee members.

And with the current 1.75%-2% target range for fed funds, the FOMC has repositioned to allow for just enough accommodation to cushion some of the recent softness and perhaps firm up inflation expectations.

That said, however, our sense is that the so-called “insurance” arguments — to soften the edges of the business sector weakness and as an early “down payment” on a later accumulative accommodation if needed — may not necessarily extend to a third 25 bp rate cut for a large majority of the Committee, including some of the voters, without a clear deterioration in the data or a further escalation of risk probabilities around the base case forecast.

An October Balance Sheet Focus

But the second and probably more important reason for a low probability October rate cut is the almost certain resumption of an “organic growth of the balance sheet” that is likely to be finalized and announced at the end of the October 29-30 FOMC meeting.

Moving beyond the problems of the internal disarray and morale issues at the New York Fed that may have had a lot to do with the bungled handling of the spike in repo pricing last week, the Open Market Desk has since responded with successive overnight repo operations and a rush of term repos to flood an abundant dollop of liquidity into the funding market to get it through the end of quarter pressures.

With so many details to the balance sheet decisions still to be made, it is probably premature to speculate on the likely scale of the resumed asset purchases. For one, the possible introduction of a “Standing Repo Facility” would seem to have many complications that would still need to be sorted out, and we would be surprised if it can be wrapped up by the October meeting. That said, a simple “organic growth” of the currency in circulation and bank balance sheets should add at least $15 billion or more a month in new asset purchases.

But the key is not really the “organic” expansion of the balance sheet with the economy, but the FOMC decision on the size of the “cushion” of additional reserves to ensure that the fluctuations in non-reserve liabilities, namely the Treasury and foreign central bank accounts, do not extinguish reserves to such an extent it drives available reserves uncomfortably below the estimated demand levels.

So aside from whether there is undue sway by the big banks over the availability of reserves, the lessons likely to be drawn from the liquidity squeeze last week and the scale of the term and overnight repo operations to date would seem to point to an overall cushion of at least $250 billion on top of wherever the Desk concludes the demand curve for reserves starts to rise.

The “QE-lite” Factor and December

Whatever the eventual total that is likely to be announced at the end of the October meeting, it will be certainly pitched as a technical adjustment; and if it is indeed announced at that meeting, we think it likely to be proceeded by speeches and research papers in the run up to October to ramp up that “technical not policy” messaging.

More to the point, we doubt there is going to be much appetite for potentially complicating the messaging on the balance sheet with a rate cut — unless, of course, the data or risks force the FOMC’s hand.

But we also suspect the Fed won’t protest too much if the market takes the resumed asset purchases as “QE lite” — which it almost certainly will — and thus still having a “policy effect” because, on the margin, that QE-lite narrative will help lend a further easing of financial conditions that the FOMC will by all accounts welcome.

In a way, it would be a mirror effect of the QT narrative that last fall had its effect on yields and pricing leading up to the fateful December FOMC presser, only this would be a more pleasant experience.

In this case, even if the QE lite effects are limited, that narrative may nevertheless produce just enough effect to neutralize the need for a rate cut in October and thus perhaps buy the FOMC some time until at least the December meeting to weigh the data and domestic political and geopolitical developments in order to gauge if, or to what extent, the broader economic conditions or risk probabilities are holding in or turning south.

Proximity to the Effective Lower Bound

One last point worth noting is the extent to which the proximity to the Effective Lower Bound is shaping the FOMC’s risk management calculations and putting an absolute premium on maximum policy flexibility in how to deploy its limited rate firepower.

Any significant downturn in the economy raises the prospect of the so-called “Reifschneider-Williams” playbook of swift, aggressive front-loaded rate cuts that could rapidly bring the policy rate to or near zero again (see SGH 8/23/19, “Fed: Setting up September”). Even the more hawkish FOMC members agree to that playbook if the economy looks to have breached a tipping point towards recession.

Where that playbook becomes tricky, however, is in how the FOMC would opt to message an aggressive rate move of 50bp, if the data or risks were to put it on the table, without triggering a sense of panic in the real economy or driving the market into immediately expecting and pricing the policy rate going right to the Zero Lower Bound.

It is important to note that no one across the FOMC thinks the economy is anywhere near that tipping point and such a calculation and messaging decision is for “down the road” rather than anything that needs to be resolved in the near term. We suspect it will be there in the background of the FOMC thinking as the calendar draws closer to the December meeting, or certainly if there is a downside shock before year-end.

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