The policy consensus taking shape on two fronts is rapidly becoming apparent in the recent public remarks by Federal Reserve officials in the run up to the Federal Open Market Committee’s March 18-19 meeting.
The first, short of Putin next invading New Jersey, is to maintain the measured pace of the taper in the bond purchases, and the second is to adopt a “Qualitative Guidance” as the next phase in the Federal Reserve’s forward policy guidance at the zero lower bound (see SGH 1/22/14, “Fed: Towards a Post-Threshold Framework”). Both are in turn being underpinned by the Nonfarm Payroll’s boost to the confidence the economy is still on course for a 3% annualized growth on the other side of the snow-swept data.
But nagging concerns nevertheless remain over the persistence of low inflation and the inability to fully explain it as well as a risk, however small its probabilities, of growth faltering in the spring. The Fed will at some point signal a more hawkish turn, but March is simply too early to do so. March instead will mostly be about recrafting the guidance language and keeping market expectations and pricing exactly where they are.
But underneath the movement towards a qualitative guidance, there remain at least three crucial assumptions that need to be addressed before a credible new guidance framework can come together. And while the issues will thread throughout the March meeting discussions, their resolution may arc across several meetings, testing the skill of new Chair Janet Yellen to shape Committee consensus at a critical transition in Fed policy.
*** How much slack is there in the labor market? Most centrists on the Committee align for now with the more dovish members that considerable slack remains in the labor markets despite the downward drift in the headline unemployment rate or that structural factors may account for more of the drop in the labor participation rate than cyclical factors most responsive to highly stimulative monetary policy. Part time and discouraged workers will be steadily drawn into the full time labor force to ensure that wage growth still has some ways to go before it raises the cautionary tale of inflationary pressures.
*** Why has low inflation persisted? Nearly all Fed officials maintain their belief that inflation will finally begin an upward climb back towards the mandate consistent 2% target over the medium term on the assumption growth will be picking up or at least not faltering. But that is what they believed last year and inflation has even fallen since Yellen first presented her case for the very dovish optimal control framework. That the Fed is still unsure of why the low inflation has persisted, or that it is global in nature, is keeping the Committee leaning towards a dovish caution on its rates guidance.
*** Where is the equilibrium interest rate? This is perhaps the single most important question driving the internal Fed debates. There is growing number of Committee members, perhaps a majority, who are coming to believe the equilibrium or neutral interest rate is lower than the commonly assumed 4%. That view is a crucial underpinning to whether or to what degree the Fed can make the case for rates that are likely to be both lower for longer and slower for longer in a gradual rate tightening trajectory. Not all of the (voting) Committee members share the view, however, or even if they do, are hesitant to formalize it in the statement for fear it would diminish policy discretion once the rate tightening is underway.
How these issues play out will determine which of the options on the table will be taken up in how to phrase the vaguer, more descriptive qualitative guidance in March, and closely linked, will also influence where Committee members place their first rate hike and year-end fed fund projections of the Summary of Economic Projections, which the market will be invariably be scrutinizing to fill in the gaps left in the vaguer new qualitative guidance of the formal statement.
Chair Yellen will certainly have her opportunity to fully explain the Fed’s thinking and likely reaction function to changes in the forecast in her first post meeting press conference a week from today. She may in fact have quite a few more such opportunities as we suspect she is likely to hold pressers after each FOMC meeting rather than the quarterly meetings in conjunction with the Summary of Economic Projections.
And importantly, we think it worth noting that Yellen will also be giving what is likely to be a major policy speech in mid-April before the Economic Club of New York. As the Chair, it will reflect as much of the consensus the Committee could agree to next week, and should lay out the likely evolution of the Fed’s forward guidance through the year, which will hopefully be firmly in place before the Fed is inevitably challenged by the market with a clear return to growth or the end of the taper later this year.
A “Firmer Handle” on the Outlook
Just about every Fed official and his or her grandmother has so far stuck close to script in attesting to their confidence that a robust enough looking recovery will emerge on the other side of the soft data for a 3% plus growth this year. Whatever is lost in the first quarter, will be made back in the second and through the rest of this year, with 2014 better than 2013, and 2015 better still, building on the housing recovery, repaired balance sheets, and the absence (finally!) of the previous two years of fiscal drag.
That suggests the Board and District projections for the March meeting are unlikely to see enough of a deviation from the underlying trend to warrant much, if any, of a potential “quarter-course” correction to December’s central tendency growth projections of 2.8% to 3.2%; at most, there could be a tweak down on the lower range to reflect any heightened uncertainty due to the expected first quarter winter weakness.
At the same time, however, several Fed officials, including Yellen in her Senate testimony, have cautioned it may take well into the spring to get past the noisy snow-swept data for a “firmer handle” on the underlying strength of the recovery. Even the April meeting, which will only offer a month’s worth of data after the March meeting due to its unusual short scheduling, may prove too early to get the fuller picture.
That means it may not be until June that the FOMC will feel certain enough on the pace of the recovery, or that it is truly close enough to an escape velocity that the downside risks can be safely downgraded.
And that ongoing degree of uncertainty, with all the endless mid-course corrections in the forecasting process, will color the policy trade-offs that will be weighed next week by the FOMC in its intended update in the evolution of its forward policy guidance.
The Forward Guidance Options
The Numerical Thresholds are certainly past their sell-by date, but to be fair, they served their purpose well in guiding both Fed policy and market expectations up to this point mostly, if truth be told, by enabling the market to ignore the hawkish of some Committee members asserting inflation risks and pressing to raise rates sooner not later.
We never thought simply nudging down the threshold to 6% or less was a realistic option (see SGH 1/10/14, “Fed: Goodhart’s Law and the Thresholds”), and in any case there is enough debate over just where the longer run trend unemployment is to nix the idea. Nor is there much chance of simply leaving the 6.5% threshold in place until April when it clearly no longer reflects how the Fed is looking at the labor market when unemployment has edged that much closer to its assumed longer run trend.
So the movement since the January meeting has been towards what Fed officials keep referring to as “qualitative guidance” to replace the quantitative guidance of the previous calendar-specific or Numerical Thresholds hand-holding.
Qualitative Guidance is shorthand for saying the FOMC wants to bring its guidance back to a pre-August 2011 style statement, before the calendar-specific or Numerical threshold guidance of the last two years, and using purely descriptive language to lay out the conditions under which the Fed would be raising rates, as a way to reinforce the data dependent — really forecast dependent — nature of its reaction function to changes in the outlook.
But beyond that, which is admittedly pretty vague to the point of not adding much to the scheme of things, the FOMC has been looking at how to list or describe the “wider array” of labor market data Yellen so famously sketched out in a speech last year.
Among them are the much-debated labor participation rate, hire and quit rates, measures of the long term unemployed and underemployed, average hourly earnings, with a look at GDP growth throw in for some context. The graphic provided in a recent paper by the Federal Reserve of New York is really is quite useful (“Eight Different Faces of the Labor Market” at http://www.newyorkfed.org/labor-conditions/).
The trick next week is whether to list these all in a coherent fashion or what else among the other options to include in conveying the same messaging up to now, that the Fed intends to keep rates lower for longer, into at least the second half of 2015.
Among the other options on the guidance menu next week will be to include a formal affirmation that the MBS holdings in the portfolio will indeed be held to maturity, as a kind of “larger than longer” addition to the lower for longer and slower for longer dovish messaging to date.
Another is to include a clear acknowledgment of concern over the persistence of low inflation as well as the global nature in the low inflation, and how that could reinforce dovish intentions; more on that score, some doves want to make sure the tolerance for overshooting on the 2% medium term inflation target is kept in the mix even if both the unemployment and inflation thresholds are nixed.
And indeed, the dovish leanings of the formulations in the new descriptive guidance can be gleaned in a reluctance for including an explicit reference to monitoring financial stability when weighing the timing and pace for the eventual rate increases; the reference higher up in the statement about “financial developments” seem as far as the majority of the FOMC is willing to go, for now – check back in by the end of the year on that front.
A Lower Equilibrium Interest Rate
But easily the biggest factor driving the dovish case in the new guidance is the argument that is gaining ground within the FOMC that the longer run equilibrium or neutral interest rate is a variable rather than fixed level.
In the current case, after five years at the zero lower bound, a subpar recovery, the persistence of lower than expected inflation, and perhaps a possible rightward shift in the Phillips Curve, has pushed the equilibrium interest rate well below the commonly assumed 4% level. That level of neutral rates may not be reached again until at least 2018 under this scenario.
Interestingly, the dot projections in the SEPs for the longer run neutral fed funds rate has in fact been quietly dropping in the two years the SEPs have been published. In January 2012, for instance, the 17 dots put neutral at either side of 4% with 9 above that level. The neutral projections has been steadily falling ever since, and by December last year, 9 of the dots were at 4 %, six of the dots were below 4%, with four as low as 3.5%. More below 4% are likely in the March longer run projections next week.
In terms of how this would come to frame the qualitative guidance, the most dovish Committee members want to include in the guidance paragraph of the statement something along the lines of explicitly affirming that rates can be held exceptionally low for a considerable period — lower for longer — and that the gradient of the rate increases is likely to be flattened — the slower for longer theme — on account the equilibrium interest rate being lower at present than the 4% commonly assumed in a normal recovery.
But those arguments are running into a fair degree of resistance, on two levels. There are those Committee members who flatly reject a lower neutral rate and are pressing for rate hikes sooner rather than later, and steeper if they have to be.
But even among some who agree the neutral level of interest rates has indeed fallen below 4%, there is a hesitation to commit to it in the formal statement. The reason has to do with disagreement over whether the rate hikes can be both held back and kept lower for longer and be increased in a gradual trajectory once the tightening is underway.
It is much easier to make the case that the lift-off will be much later than it would normally have been, and the risk/reward in any case also points in that direction in that the cost of needing to catch up if wrong is much lower than the cost of being premature in the hike and being pushed back to the zero lower bound again.
But it is still another thing to also commit now in the guidance that even after the rates are lower for longer that the Fed is likely to raise the rates only very gradually, when by then growth and employment are well back to trend. So for those who worry about the distinction, maybe the guidance should be confined to the timing of the lift-off itself shying away from going any further after that on the pace of the rate trajectory.
The neutral interest rate issue is a central one, but it may not be resolved in the March meeting, and perhaps the compromise next week may be to simply state that the neutral interest rate is a variable not a fixed level, and leave it at that. But finding a consensus may also take several meetings, and it may have to wait until even the September meeting, by which time either the data will prove the case one way or another, or the September SEPs will bring some clarity on where Committee members stand when the 2017 projections enter into the picture.
The Dots and a Possible SEPs Revamp
The Fed is very aware that the markets are likely to lean even more heavily on the dots for signs of the lower for longer rates in the wake of the shift to a vaguer qualitative guidance in the statement.
But the FOMC faces a conundrum of sorts in being forced to rely too heavily on the dots to convey the intended rates guidance of the (voted) statement because each Committee member goes into the meeting with their staff projections for growth, unemployment, and inflation before they debate and decide on the rates guidance that will go into the statement, and even then, of course, only a dozen actually vote on the statement guidance.
As we reported last month (SGH 2/12/14, “Fed: The Bullard Takeaways”), the dots have been problematic in that sense for the Fed in terms of neatly fitting into their forward guidance because the dots in any case were not originally meant as guidance, but to show the wider Committee process with the 19 different forecasts on growth, inflation, and unemployment based on undisclosed assumptions of trend and the appropriate policy path.
With all the caveats above, we still suspect the March dots guidance on the first year of a rate hike and the year-end fed funds rate projections may not differ all that much from the very dovish clusters of the December dot projections. That is mainly because as we noted earlier, it is still too early to make a decisive call on the pace of the recovery, and that risk management considerations are likely to keep rates guidance highly accommodative since the cost of the downside risk is higher than the risks in growth or in the unlikely case of stronger than expected inflation.
Even under the optimal control framework, the dots could edge modestly higher from their very dovish cluster in the December SEPs, on account the trade-off in the cost/benefit of faster employment growth in the near term at the cost of potentially higher inflation in the medium term narrows the closer the forecast gets to trend.
But then again, inflation is currently lower than it was when then vice chair Yellen first laid out the very dovish rate path in her two “optimal control’ speeches in late 2012 and early 2013.
One of the other options the Fed is looking into in terms of revamping its policy guidance is to expand the SEPs to provide more of the narrative backstory to the Fed’s thinking and expectations, and to lay out the wider array of labor and other data high on the Fed’s radar screen to better give a sense of its likely reaction function to changes in the forecast.
The Fed has looked somewhat fondly to the Bank of England’s recent change in its guidance and to its Quarterly Inflation Report as a model of sorts, and it feels familiar because the communications subcommittee chaired by then Vice Chair Yellen a few years back had looked hard into adapting the SEPs along those lines.
There are also technical and operational difficulties, since the SEPs would have to be brought forward from the Minutes to be released at the same time as the Statement. So it may be a revision to the guidance for further down the road. But such an expanded SEPs, and if they could be brought in line with the timing of the statement’s release, might perhaps offer a tighter linkage between the dots guidance on rates and the forecasts.
Locking in Current Expectations
In any case, there is no small irony in the effort to adopt the qualitative guidance as the next phase to the Fed’s forward policy guidance, and how it will be integrated, ideally, to the dots guidance, since, for the most part, there is no intended change in policy.
Market expectations are perfectly priced and aligned with the Fed’s own expectations of a first rate hike sometime in the latter half of 2015. So in an ideal world, the guidance would merely lock in current expectations rather than pushing back on any market premature pricing of rate hikes as before, and that is a big difference.
But there is an important underlying objective in phasing in the more qualitative descriptive guidance, namely, that a majority of the FOMC want more policy discretion at this stage of the recovery when it (unemployment at least) is slowly edging closer to trend. That may well prove to be the crux of the debate on how exactly to fashion the new guidance framework.
A more vaguely defined qualitative guidance that by design will both leave the Fed more discretion in its policy moves from here and modestly lessen its heavy hand in shaping the yield curve. There is in fact a certain lagged but parallel intended movement in the two primary policy tools since policy reached the zero lower bound.
Just as QE and the Fed’s bid in the long end of the bond market was wound down slowly through the taper, so too will the guidance on future policy see a gradual stepping back from the more explicit calendar-specific guidance of a few years ago, through the Numerical Thresholds, and back to the pre-August 2011 style statements of the vague conditions to a change in policy. If it may mean a little more volatility, so be it.
But the bet is that this very gradual withdrawal of the Fed’s heavy hand in both purchases and guiding the markets on the shape of the yield curve will translate into far less volatility when the Fed does finally begin to lift rates and begins its long sought Exit from what will have been seven long years of unconventional policy measures at the zero lower bound.