When the Federal Open Market Committee finally limps into their two day meeting tomorrow they will no doubt weigh what to take from the most recent data. But perhaps the single most important item on the agenda will be to sort out the mess in their policy messaging since the “close-call” September meeting – a Halloween reset of expectations, if you will.
*** While there is no chance of a rate hike this week, we do believe an FOMC majority still expects conditions to warrant a start to policy normalization at the upcoming December meeting. Softish data and their own contradictory signals have complicated the approach to year-end, however, sowing confusion over the Fed’s reaction function. That repair will only begin with the statement on Wednesday, which we think will keep a December hike on the table, but not much more than that. ***
*** To that end, we expect the FOMC in Wednesday’s statement to affirm continued “moderate” growth, perhaps cite “cumulative” gains in the labor market to offset the slower net new job growth, and, we suspect, soften somewhat the sentence on the international risks to the US outlook. A new sentence, that policy will remain highly accommodative long after the start to policy normalization, may not make it into the statement itself, but it will figure prominently in subsequent Fed remarks and in the meeting Minutes. ***
*** Assuming the data behave to the Fed’s base case expectations, however, a December rate hike is still going to be difficult to telegraph in a credible, timely fashion. And while it is entirely possible the timing to a first rate hike could still slip away from December towards a reset into next year, the “sooner and slower” base case policy path will be fiercely defended against the “later and faster” minority alternative, even if it entails dissents. ***
Repairs to the Reaction Function
The Fed’s reaction function, which has never been all that clear if truth be told, was cast even further into confusion in recent weeks both by weaker than expected data and especially by the flat out sharply diverging public views of FOMC members on how to interpret the data or question the Fed’s base assumptions on the linkages between employment and inflation (SGH 10/14/15, “Fed: Houston, We Have a Problem”).
For most of this year, the messaging workhorse phrasing has been a “data dependent” policy path, but its vagueness that worked so well in holding together a Committee consensus on communications has been, as the decision on a first rate hike approaches, fast wearing thin and is now pretty much past its sell-by date.
The repair to the reaction function will first need a consensus at the meeting on the communications to take from here, and that, we think, will translate into a better framing of the “data dependent” policy path into the December meeting. That, for instance, may mean more public remarks in the coming weeks that the Fed does not necessarily need to see stronger China or global growth, just the absence of a hard landing, or that US growth, even if tepid, is still “good enough” and above trend growth to set the conditions for a first rate hike.
In that context, the recent easing hints and measures by the European Central Bank, the People’s Bank of China, or the potential further easing moves by the Bank of Japan are less ominous than seems to be assumed by a bearish-tilting market, in that whatever near term impact the combined policy moves abroad may have on the dollar is more than offset by the improved prospects in the medium term where Fed policy operates for global demand or at least in putting a floor under further declines in demand.
Likewise, as we noted in a recent report (SGH 10/5/15, “Fed: The NFP and Its Aftermath”), the Fed had been expecting the pace of US job growth to decline from its previous pace north of 200,000 jobs as the labor market was pushed towards its assumed longer run levels. That it fell so sharply in a single month in the September numbers was disappointing and a surprise, but the downward revisions in the previous months tells a clearer picture of the anticipated more gradual decline in the pace job growth.
Several Fed officials have tried to put that more positive spin on the lower job numbers, in effect that 100,000 is the new 200,000 a month in jobs. But that effort came only after, rather than before, the September payroll print earlier this month, and the disappointing payroll print coming so soon after the insertion of the sentence about international risks in the September statement, not to mention passing on a rate rise, only added further fuel to the torrent of gloom that now dominates market expectations and pricing.
We think along those lines that the FOMC may try to limit the damage done in how the data is interpreted and to at least keep a December first rate move in the frame by inserting a clause in the labor market sentences of the statement on Wednesday to note “cumulative gains” in steadily removing slack from the labor market as way to reframe the way the labor market trends are seen.
And going forward, the Fed will be watching the employment data closely for signs of further tightening in the outer edges of the labor market, such as more part time workers finding fulltime employment, or the long term unemployed or discouraged being drawn back into the labor force. Evidence of higher wages would be nice as well, but frankly is not as expected just yet, or in any case, is increasingly seen within the Fed as a less reliable indicator of labor market tightness than it might have been in the past.
A Battered Phillips Curve
Likewise, far too much is being made over the diminished value of the Phillips Curve in the Fed’s base case inflation outlook? But it is and will remain at the center of the Fed’s mostly slack-based forecasting models and assumptions. Two points are likely to be made going forward.
First, no one in the FOMC, including the most ardent hawks, believes there is a near term inflation risk. The inflation risk is a more distant threat, several years down the road perhaps, but the issue is about ensuring the policy flexibility of a very gradual upward slope in the rate path to protect against future rate hikes that are too rapid and which could derail the real economy recovery or such a spike in the term premium it destabilizes the financial markets.
Crucially, the gradual ascent also ensures that financial conditions will remain highly accommodative for years to come even as the normalization of policy starts with that first rate hike. And to protect that flexibility of a preferred gradual rate trajectory, the base case consensus for a large majority of the Committee is to begin moving off the zero rate well before the evidence of rising core inflation or wage growth is clearly in the data.
To be sure, the exact timing of the trade-off between tight labor markets and rising inflation that lies at the heart of the battered Phillips Curve conceptual framework is not entirely clear. But it is there, and at some point next year, the clear majority of the FOMC believes that upward pressure will begin to show up in the data for service sector prices in particular, while at the same time, the downward pressures of the strong dollar and low oil prices will begin to drop out of the data through next year with the fading fears of hard landings and perhaps even rising global demand.
For a Committee majority — which we believe includes Chair Janet Yellen and certainly Vice Chair Stan Fischer — the arguments made by a minority of the Committee for a “later and faster” rate path bears a far higher risk of financial dislocation and a potential derailment in the recovery than the potential cost in reversing a premature first rate hike in this base case for a “sooner and slower” trajectory.
That is why, we think, even if a first rate hike to the start of policy normalization is pushed past December, it will only be on the grounds the anticipated labor market upward pressure on prices and fading dollar effects have been pushed back in the forecasts deeper into next year or into 2017, not that the Phillips Curve assumptions are being questioned or abandoned altogether.
Looking beyond the October meeting, there are three last points to keep in mind. First, the data is still more likely than not to be just beyond tepid, but still warm enough to warrant consideration of a rate hike amid the cold illiquidity of December.
The second is that if that data is indeed supportive, in terms of the internal consensus building, we rather suspect Chair Yellen is more than willing to take a dissent or two in stride. Those may come not only with the first rate hike from the more dovish Committee members, but down the road, from the more hawkish-inclined rotation of voting Committee members next year over what is likely to be a very gradual pace of the initial rate hikes.
And third, the external equivalent of absorbing dissents is a probable willingness to push ahead with a rate hike even if it is not fully priced into market expectations. There is a view taking hold within the Committee that for all its efforts to well telegraph the first rate hike after seven long years at the Zero Lower Bound, those pricing probabilities may never get much beyond 50-50 odds. But even odds are nevertheless odds we suspect the FOMC would be willing to take, even in the assumed illiquidity of the last month of the year.
Then again, the trend in the labor markets may in fact be one of slowing gains, or that overall growth is slipping back towards trend, or even slipping below, or the efforts by the central banks abroad may come to naught. In that case, all bets will be off and the Fed will by Thanksgiving or soon after be moving well away from a start to policy normalization before year-end and already resetting expectations for, well, March or later in 2016.
The point is for now, the effort behind the crafting of the October statement is likely to be simply to keep the December option on the table, and to start a repair on the reaction function to better prepare market expectations for a rate decision to come, premised on still moderate if hardly spectacular growth. But that also means, for now, despite the rush of Street commentary to the contrary, there is no “Plan B” in the works inside the Fed for reversing its current policy path with a new round of QE4, negative interest rates, or capping longer term yields.
And while the market is pricing very low probabilities for a December rate hike, the six or seven weeks to mid-December is a long time in policy messaging terms. And a rapid cascade of messaging is already being teed up for the eve of the mid-December meeting black-out period, with Chair Yellen set to give high profile speech before the Economic Club of Washington on December 2, followed the next day by testimony before the Joint Economic Committee on December 3, and with the week ending with Friday’s Nonfarm Payroll.
We doubt there will be any uncertainty about the December meeting rate decision by then.