Fed: Eyes Wide Open

Published on January 9, 2019

Federal Reserve Chairman Jerome Powell’s carefully scripted messaging last Friday was a near master class in the art of finely tuned messaging, vaguely offering just enough in such reassuring tones that a rattled market could hear what it wanted to hear but essentially committing the Fed to no particular policy path.

This Thursday when he speaks before the Economic Club of Washington, Chairman Powell will be seeking a messaging balance between keeping market anxieties quelled in an “eyes wide open” approach as New York President John Williams put it, while nudging forward with perhaps a bit more flesh on the Fed’s risk management approach that keeps all its policy options on the table. 

*** The conditional nature of the Fed’s forecasts and the wide variance of potential outcomes around the base case rate path is likely to again feature prominently in the Chairman’s remarks in the moderated discussion tomorrow lunch time. Policy is not on a preset course, and the December median of two rate hikes this year “illustrates the broad middle” and indicates neither a Committee consensus nor a commitment. Highlighting the wider range of potential policy paths in further hikes, an extended pause, or even, albeit unlikely, cuts is one way to keep the Fed’s options open while conveying a heightened sensitivity to market conditions and downside concerns. ***

*** The Federal Open Market Committee consensus is indeed solidifying for a pass or pause on rates in March, largely on the back of the unexpected persistence in low inflation and perhaps bolstered now by market signals of downside risks. But that said, still resilient growth momentum into 2019 should limit the sharpness of a slowing this year that is both expected and needed to safely navigate to a soft landing. We think against that backdrop, the FOMC majority would still be willing to weigh a May rate hike, barring a southern turn in the data. The inflation prints in the coming months will be key to the rate stance through the first half of this year. ***

*** We also suspect Chairman Powell and Vice Chairman Richard Clarida, who is also giving an important policy speech tomorrow night, may seek to delicately walk back more aggressive expectations for a near term change to the current balance sheet run-off. While much of the market took last week’s promise of “flexibility’ on balance sheet policy to mean ensuring enough liquidity to prop up asset prices, few if any Fed officials see any such a link, even if they do cede a very modest added tightening effect. Instead, a likely larger rather than smaller balance sheet as well as a shortened time frame to the eventual decision on the operating framework may be offered as reasons to any possible changes in asset run-offs. ***

We should add the Minutes to the December FOMC meeting being released later today may have even more of a rearview mirror feel to them than usual in light of the volatile market conditions and the more recent message fine tuning by Chairman Powell and others. 

But while the market may be mostly skimming for further evidence of the Fed’s balance sheet thinking in a likely summary of how far the Committee progressed on the issue since the November meetings first round of discussions, we strongly doubt there will be any indication the FOMC believes there is anything to the assertions the steady and predictable balance sheet shrinkage is significantly adding to market volatility. 

The Risk Management Narrative

The disconnected narratives of a data-dependent Fed that still sees a robust economy with plenty of momentum going into this year versus a market undergoing a volatile repricing of risk is putting an absolute premium on the Fed’s tactical risk management approach, particularly in crafting its messaging as well as laying out its base case policy path.  

After December’s messaging was so dramatically drowned out by downshifting markets, Chairman Powell succeeded last Friday to reframe the Fed’s communications to deliver essentially the same policy message he laid out in December but in much more soothing tones.  

With former Chairs Janet Yellen and Ben Bernanke alongside him on the stage at the American Economics Association conference in Atlanta, Powell carefully referred to the notes in his lap to reassure jittery markets that while the Fed’s base case was for still resilient growth this year above trend that may necessitate two rather than three rate increases, the Fed was hardly going to ramrod rates higher without paying heed to the market’s fragilities and potential signals for a further softening in the outlook. 

A base case for further rate moves deeper into the broad range of neutral estimates is just that, in other words, a base case entirely open to mid-course adjustments depending on how the data feeds into the continually updated forecasts.

And with the “muted” inflation outlook affording the central bank some running room to gauge the lagged effects of the rate hikes to date, Powell went out of his way on Friday and is again likely tomorrow to signal the high likelihood of a pass or “patient pause’ on another rate hike at the upcoming March meeting.

In breaking the previous run of quarterly rate hikes, the Fed can take its time to keep an eye on downside risks, and if they do materialize against its expectations, the Fed is “always prepared to shift policy and to shift substantially when needed to achieve twin mandates,” Powell asserted in Friday’s key takeaway sentence. 

He notably added that “the Fed is indeed willing to use ALL tools deemed necessary” and went even further, perhaps too far for many of his colleagues on the FOMC, to reassure that “If we ever came to the conclusion that any aspect of our plans was somehow interfering with our attainment of our statutory goals, we wouldn’t hesitate to change it, and that would include the balance sheet.’’ 

To be fair and balanced, Powell did also quickly add that the Fed doesn’t in fact believe the run-off of assets on the balance sheet is an “important part” of the market turbulence since last quarter, an assertion that was readily picked up by other Committee members, including Cleveland’s Loretta Mester and Atlanta’s Rafael Bostic. Powell and other Fed officials also noted the obvious, that the amount of bonds the Fed is putting back into the market in gradually scaling back its reinvestments is minor compared to the near-doubling of Treasury debt issuance this year. 

No matter though, the market for the most part chose not to hear the critical caveat, and our sense is that for many Fed officials, the reassurance may have gone a tad too far in setting a dangerous precedent in setting up excessively high expectations for a balance sheet response every time asset prices swoon.

Refined Messaging

Beginning with the New York Fed’s Williams being wheeled out before the cameras the Friday after the December meeting and culminating with Chairman Powell’s star turn on Friday, the Fed has more or less been successful in its messaging risk management tact to walk the markets back from a risk-off downward plunge that could have threatened a self-fulfilling doom loop potentially spilling over into the real economy. 

But we suspect there will need to be some further elaboration of the Fed’s policy path going forward on both the balance sheet and the rate stance.

The first is an essential clarity on the balance sheet policy. There is nothing in the remarks on the balance sheet policy to indicate the FOMC has any intention to alter pace of its asset run-off solely on account of turbulent stock markets. Indeed, if the narrative shifts to the assertions the Fed needs to provide abundant excess reserves to keep risk appetites high and asset price levels inflated, it would quickly translate into a new and even more dangerous version of the infamous Fed “put,” something Powell in particular is keen to resist and dismiss.  

Our sense is that the “flexibility” that Powell referred to was more about when the FOMC believes the level of reserves will be low enough to support its execution of monetary policy or that he was referencing the willingness of the FOMC to expand the balance sheet again if its primary rates policy tool is again constrained by the effective lower bound; rather than with potentially slowing or halting the asset run-off to protect stock market liquidity or a high risk appetite that keeps asset prices higher. 

But a way to navigate between market expectations and the Fed stance on the balance sheet policy may come through addressing some of the unresolved questions on the minds of the markets: why, for instance, are rate hikes “data dependent,” but the balance sheet runoff is not equally data dependent? Or if QE was meant to signal an accommodative policy stance, why doesn’t its reverse, the so-called “quantitative tightening,” signal a restrictive policy stance?  

And perhaps more to the point, if the Fed does opt to pause on rates, still continuing in the shrinking of the balance sheet, however modest the tightening effect, would complicate the policy messaging in that the twin tracks to the Fed’s policy normalization strategy would look to be pulling in opposite directions. 

We suspect that either Powell or especially Clarida in his speech before the New York University Money Marketeers will offer some further detail on the balance sheet policy, perhaps in hints of how the FOMC is leaning towards an eventually larger rather than smaller balance sheet, and that the remaining run-offs in assets to achieve this optimal size would dictate any change in the pace of balance sheet shrinkage.  

Likewise, we also suspect the FOMC will be forced to accelerate their decision on the eventual balance sheet policy and all its complications, the policy tool, the floor versus corridor or some modified hybrid, and the critical internal governance issues of whether the broader FOMC or the narrower Board of Governors alone will vote on rate and balance sheet policy going forward (see SGH 12/21/18, “Fed: The Balance Sheet Question” and SGH 7/27/18, “Fed: The Balance Sheet”).

Keeping Hikes on the Table

One last point on the rate front, while Powell again noted the Fed’s caution in 2016 as an example of the current risk management approach, left unsaid and barely registering in the instant analysis was that he was being equally careful to avoid committing the Fed to any actual dovish policy path that mirrored the market’s anxious recession pricing for an end to rate hikes. 

Indeed, he never took rate hikes off the table at all — a point that Chair Yellen managed to slip into her own remarks, noting that further rate hikes was probably warranted. Underscored by Friday’s blow-out employment report, it is for a FOMC majority hard to envision the recession on the near horizon the market is pricing when so many jobs are being created, and aggregate demand is still so resilient.

Indeed, in terms of where the committee consensus is, while the no-show of higher inflation allows the luxury of patience through the first quarter of this year, we think that patience may wear thin by the May meeting if the data doesn’t display a marked slowdown in growth, with the center of gravity within the Committee still nursing an ambition to set up for a rate hike at the FOMC April 30/May 1 meeting. After all, the economy is supposed to be slowing and needs to be slowing or else an even more aggressive pace of rate hikes would enter into the policy debate.

But key to a decision by then will be whether inflation stays as inertial through the first half of this year as it proved to be by year-end. That the Fed is still so uncertain of the evolving inflation dynamics, a theme we stressed through last year (see SGH 12/19/18, “Fed: The Persistence in Low Inflation,” and SGH 9/26/18, “Fed: A Still Assumed Inertial Inflation”), is perhaps the single biggest reason for the wide variance around the base case rate path this year. 

While the median of the core inflation projections did dip a tenth back to 2% in December from the very modest overshoot of the target to 2.1% in September, there are some staff within the Fed system who are arguing inflation may already be peaking and with the assumed fading of the fiscal stimulus through this year, core inflation may drift lower still. 

By summer, the Fed, and the market, will both know who how inflation is playing out this late into an expansion, and indeed, how it will factor into the Fed’s review of its monetary policy framework through the course of the year.

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