Fed: Holding Back the Tide

Published on December 14, 2016
It was awfully hard not to notice how many times Federal Reserve Chair Janet Yellen repeated how “modest” or “moderate” the changes by “some” of her colleagues on the Federal Open Market Committee were in today’s economic forecasts and especially the rate dot projections, which once again, delivered more confusion than clarity on the Fed’s most likely policy path.
Indeed, the contrast between Chair Yellen’s messaging and what could be taken from the rate dot projections was perhaps the most stark in memory.
*** In a repeat performance of December 2015, Chair Yellen seemed especially determined to play down the hawkish signals of the uptick in the pace of projected rate hikes across the forecasting horizon. She did all she could to stick to a more dovish base case policy path, pushing back on “modest” changes by “some” FOMC members, or pivoting every question on a widely expected fiscal stimulus to the uncertainty of its effects. ***
*** If the misleading effects of those hawkish outliers to the Committee majority consensus are stripped out, she was in effect asserting, the rate dot plot would have hued close to the same path mapped out in September, and to a likely two rate hikes in 2017, and as we noted previously, a possible third hike in reserve as insurance against an upside inflation surprise (SGH 12/12/16, “Fed: December and Next Year’s Rate Path”). ***
*** But try as she did to hold back the tide of market expectations for a hawkish Fed reaction function to the slightest signs of higher inflation or a significant fiscal and tax policy stimulus to growth and demand, the main takeaway for us today was a sense at minimum that the risks to the Fed’s messaged base case policy path is to the upside. ***
Rates Higher to Keep Inflation on Target
The Summary of Economic Projections barely budged from September, with inflation projected at the same 1.9% in 2017 and 2% in both 2018 and 2019 as in September, while growth was projected slightly stronger by a tenth of a point in 2017 and 2019. But unemployment was projected to fall a bit more, to 4.5% in 2017, with the lower end of the full 17 member range touching 4.4%. And since the Committee’s estimate of the longer run unemployment level, or NAIRU, stayed at 4.8%, the only way for a handful of FOMC members to keep inflation in the same expected range was to mark up their rate projections.
Thus it looks like seven Committee members moved their projected rate hikes up for 2017, which proved to be more than enough to lift the median federal funds rate in 2017 to reflect three instead of two hikes. Interestingly, three rate dot projections look to have been lowered, suggesting a convergence of rate views next year however much the modestly faster pace is downplayed.
2018 and 2019 saw the same upward tilt in the pace of rate hikes, including a near majority of the FOMC envisioning an outright tightening of monetary conditions by the end of 2019, with seven rate dots at or above the assumed longer run neutral level. And indeed, for the first time we can remember, the median estimate for the longer run neutral went up a tick, back to 3% from 2.9% in September, with the upward pressure in fact coming from estimates at the bottom of the September range being revised back up. For an estimate that is not supposed to move around very much, it is a remarkable reversal in a very short time.
Adding to the confusion – and underscoring how badly needed a serious revamp of the SEPS and rate dot projections is – Chair Yellen said “only some” of the Committee members marked their dots up on the basis of an assumed higher level of fiscal stimulus – even if the scale and timing is anyone’s guess — while most did not (at least not yet). Then again, some marked their rate projections up a tad on the grounds of the tightening labor market, while still others either did not see that leading to higher inflation or were willing to see a modest overshoot of the inflation target (there were at least a few Committee members marking their 2018 and 2019 inflation projections at 2.2%).
Indeed, in contrast to “some” of her colleagues who seemed so sure of the stimulative effects of an eventual fiscal policy boost on inflation, Chair Yellen did her best to soften the hawkish assumptions of a fiscal reflation by pivoting every question on fiscal policy to the uncertainty of knowing what is coming down the pike, what its effects might be on the economy and inflation, or the markets, and what the effects of other factors like the dollar will be. Uncertainty is still the main effect of the election.
So while that would suggest taking the entire SEPs and rate dot projections with a huge grain of salt, it does raise the question of what the rate dot projections will look like as early as March or June next year when there should be a far clearer picture of the fiscal and tax policy outlook – and when the economy is already at full employment and at mandate-consistent levels of inflation. It suggests short of a shock economic downturn, all the near term risks are to the upside.
And on that note, it was interesting that despite the rate hike, the Committee chose to keep the near-term risk assessment at “roughly balanced” rather than upgrading to “balanced” as might be expected to accompany a rate hike. Perhaps that signal is being kept in their back pocket until they see more certainty on the fiscal policy path.
A “High Pressure” Backpedal
There was also a somewhat curious, seeming back-pedal from the questions she raised about a “high pressure” economy in her speech last October in Boston. At several points, she insisted she did not mean to suggest she “favored” a monetary policy accommodative enough to run the economy so hot it would potentially pull enough workers back into participation in the labor force or even to potentially lift the economy’s productive capacity.
But while it may have been rhetorically poised as a “research question,” when the Chair of the Federal Reserve, whose entire academic work has been in the labor markets and monetary policy, is throwing the question of monetary policy potentially triggering changes that would “permanently change the labor participation rate and productivity” out into the public domain – and when the economy is already at full employment, it is certainly a lot more significant than a mere research question.
In poker terms, perhaps it was something of her “tell,” that while she herself and what we think is a probable majority of the Committee is still leaning to two hikes next year and  letting the economy run hot for a while, it did occur to us that in her stepping “modestly” away from the high pressure scenario the Chair may be repositioning within the Committee just in case the consensus by the final few meetings of the year moves to a more aggressive rate path because inflation is rising faster than expected.
Taking everything this afternoon on board, perhaps the clearest broad policy messaging we took away is just how splintered or diffused the reaction function of the individual Committee members is to the likely developments and evolution of the economy next year, be it the timing and scale of the fiscal factor or the linkage between a tight labor market and inflation.
And that is before two or three new Governors arrive in the first half of next year and a triumphant White House and newly emboldened Republican majority on Capitol Hill takes up monetary reform legislation. To us, all that translates into what is going to be a very interesting crossroads in the Fed’s long trek from the darkest days of the crisis and, indeed, for what could be a volatile year in the markets.
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