Fed: Houston, We Have a Problem

Published on October 14, 2015

The reverberations in the wake of the stunning remarks made by Federal Reserve Governors Lael Brainard and Dan Tarullo in the last 48 hours will be many, but all are pointing in the same direction of a Federal Open Market Committee consensus on the near term policy path that is essentially in tatters.

*** The timing of the Brainard and Tarullo assault on an admittedly already fraying consensus for a December first rate move may have been driven in part to temper any effort to harden up the October meeting statement to include a more explicit signaling of the likelihood of a December start to policy normalization. In any case, underscored by the lackluster retail sales print this morning on top of the disappointing Non-Farm Payroll, and with a market already even more deeply priced for 2016, making the case for a December rate hike is going to be challenging, to put it politely. ***

*** Indeed, the cost in dragging out the policy uncertainty of its “data-dependent” path is rising, which we think is making October, not December, the pivotal FOMC meeting. Not that the FOMC might raise rates then — the odds for that are between nil to none – but rather that Chair Janet Yellen will have to scramble now not only to bridge the deepening, almost binary split within the FOMC on the timing to a first rate hike, but to save the base case for a likely “sooner but more gradual” rate tightening trajectory that was the heart of the Committee consensus so laboriously constructed since at least last spring. ***

An Unraveling Consensus

Both Brainard and Tarullo have long been known to be among the more dovish Governors on the Board, but other than an occasional dovishly-intoned previous speech or two, neither has ever veered far from the public base case laid out by Chair Yellen and Vice Chairman Stan Fischer. And despite any short term damage to the Fed’s credibility in the prudent caution to delay a first rate hike in September, most of the FOMC has been quick out of the gate since to reset the policy messaging that it was a tactical, not strategic, retreat (see SGH 10/5/15, “Fed: The NFP and Its Aftermath”).

But in their public remarks earlier this week — Tarullo even rushed to get his views out there by scheduling an on-air CNBC interview immediately after Brainard’s prepared speech Monday night — both Brainard and Tarullo not only questioned the merits of a first rate hike in December, but they explicitly questioned the entire conceptual framework behind the case for a “sooner” rate hike, namely, a measure to be taken in order to ensure maximum policy flexibility for a likely gradual ascent in the pace of the subsequent rate hikes.

For the two Board Governors, both of whom are former Obama and Clinton Administration policy makers, to take such a sharply contrasting stance to the leadership in public has the eerie echoes of the infamous rebellion in 1986 against then-Fed Chairman Paul Volcker by Vice Chairman Preston Martin and Governors Wayne Angell and Manuel Johnson. That rebellion by the Reagan Administration appointees on the timing to a rate cut so damaged Volcker that even though Martin soon had to resign, Volcker also exited the Chair the following year, to be replaced by Alan Greenspan.

Though hardly on the same scale, the very public rebuke by Brainard and Tarullo just days before the pre-October meeting black-out is nevertheless damaging to the Fed messaging at an especially difficult moment. For our sense is that what is at stake is not just a December rate hike, but the entire architecture of the Committee consensus Chair Yellen has been so laboriously constructing since last March, if not before.

Yellen takes her role as a consensus builder very seriously and that consensus was essentially being built around a trade-off, to trade an earlier rate hike than most preferred — including herself — to placate the hawks on the Committee in return for the commitment to satisfy the more reluctant doves to a very likely gradual pace in the subsequent rate hikes that would ensure a still highly accommodative monetary stance for essentially years to come.

The gradual tightening also had the benefit of ensuring maximum policy flexibility, to go as slow as may be needed to protect against getting too far ahead of a slowly rising effective equilibrium real interest rates that might slow or even derail the recovery, or moving so rapidly with rate increases it might up-end a bond-heavy fixed income market needing a long runway to adjust portfolio positions.

But once rates are more “normalized” beyond, say, a 1% fed funds rate, the FOMC would still be free to move more quickly if needed, depending on the behavior of inflation and whether the tightness in the labor market was indeed underpinning higher services inflation that more than offset the assumed dissipation of the downward pressures of the strong dollar and weak oil price on goods inflation.

That much-prized policy flexibility may now be at risk in a delay to policy normalization, especially if it gets extended well into 2016 amid all the risks of hiking in the middle of a volatile presidential election year. The FOMC may seek to make the case that the persistence in low inflation and what is likely to be a slow, inertial rise in inflation back towards its mandate-consistent levels will still allow for the gradual ascent in a rate tightening cycle, but the odds for that are admittedly going to be vastly lowered.

That, in turn, is elevating the risks in the minds of many Committee members of rapid rate increases even, say, in back-to-back meetings. While many outside critics of the current Fed path and some FOMC members argue that is not necessarily a bad thing, the concern among a majority of the Committee — we think including Yellen — and staff has been that a too rapid move in rates could trigger the very sort of nasty dislocations and financial instability in the fixed income and currency markets the Fed has sought to avoid in mapping out the optimal policy path to escape the Zero Lower Bound.

Moving Away from December

At the same time, however, at least to some degree the Brainard and Tarullo remarks may prove to be but the front edge of a broader rethink across the FOMC over the likelihood of a first rate hike in December.

It was our sense going into the September meeting that the Chair Yellen, for instance, was already becoming a bit more hesitant about the first rate hike that was being messaged for a high likelihood as soon as September, and that she was personally leaning towards December (SGH 9/14/15, “Fed: When in Doubt, Move the Pawn”). We thought, wrongly it turned out, that she would nevertheless endorse the first rate hike move in that “close-call” meeting in order to protect the broader consensus rather than risk it unraveling in the subsequent weeks — which it seems, is indeed happening.

And even if she did drop that “including myself” clause into her Amherst speech about expecting conditions to warrant a first rate hike before year-end, the signals amid the noise of the most recent data has the look and feel of extending into next year the very prudence in a delay to starting policy normalization that caused the hold on a first rate hike last month.

However much data like the lower than expected print on the September Non-Farm Payroll is spun as more neutral than soft, or pointing to the same tepid-temperature growth of the last year or more, Vice Chair Fischer in any case undercut the messaging that a 100,000 a month job creation is the new 200,000 in his acknowledgement in Lima that it was “disappointing.”

Indeed, even Fischer, who we think has been one of the more assertive proponents to a start to policy normalization this year, seemed to caveat that base case path more than usual in his remarks on the sidelines of the International Monetary Fund/World Bank meetings in Lima last week. And Federal Reserve Bank President Dennis Lockhart, long considered a key bellwether to the Committee consensus, likewise conceded greater uncertainty even as he stuck to the base case messaging that the data was likely to clear the conditions for a first rate hike in December.

October as the Pivotal Meeting

This is not to say a December meeting first rate hike is dead on arrival, but not only are the necessary supportive data somewhat lacking, but the Fed messaging to better prepare the markets to tee up a hike looks to be daunting.

One of the arguments, for instance, for September as the sweet spot for a start to policy normalization was the operational hassles of October due to the absence of a press conference and more importantly, the out of the ordinary market illiquidity in December. The latter was, in theory, going to be overcome by telegraphing a rate hike likelihood so well in advance on the back of cooperative data that it would effectively be but validating that first small rate hike already priced into the market. That assumption is now in doubt.

So to keep December a “live” meeting, as they all have been after April, many if not a majority of the FOMC were thinking they might need at minimum to prepare the path to December by bolstering its descriptive language of the economy in the October meeting statement, perhaps something along the lines that the “cumulative” gains in job creation indicate slack is being removed and that labor market resources are no longer underutilized. That may still prove to be the outcome in the drafting of the October statement, but it would be a contentious point of debate in the meeting the week after next.

And it may also account for the very public questioning of the Phillips Curve assumptions, admittedly, that Yellen herself acknowledged, even as she asserted its overall conceptual usefulness in framing a policy path.

We do think the attacks on the Philips Curve are being vastly overstated, but the point is not the merits of the Phillips Curve per se, but that the eventual higher inflation that would come in the wake of a labor market well through its assumed longer run levels or NAIRU may be a lot farther away than what would be comfortable in seeking a “reasonable confidence” in the forecast for higher inflation.

More importantly, however, is that it may likewise prove to be very difficult for Chair Yellen and her colleagues on the FOMC to back pedal from a December start to policy normalization and still save the assumed gradual trajectory. That may entail a tricky tweaking to convey a new policy narrative shifting base case expectations into 2016 – or rather, confirming where the market already is – that could strain Fed credibility at an especially sensitive juncture.

That points, in fact, to what may prove to be Yellen’s most difficult challenge, one that will only start, not end, in the October meeting. And that is the need to somehow reconcile what are essentially two competing orthodoxies in how to interpret and model what is going on in the real economy and how much the global price pressures and faltering growth are now intruding into the assumptions of the domestically-driven consumer spending and rising aggregate demand that are propelling US growth just north of its repeatedly lowered trend potential.

The secular stagnation that seems to be deeply entrenched in market expectations and pricing is threaded throughout the New Keynesian Phillips Curve assumptions of a slack-based view of the world in the repeated reduction in the economy’s trend growth potential. But for the latter it is seen as more cyclical than structural in nature as it is in the former, and therefore more “correctable” with the right monetary policy mix.

Increasingly, however, one or the other may soon prove to be more right than wrong, with all the consequences it may imply for both monetary and fiscal policy in the near time ahead.

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