Fed messaging at Jackson Hole was impressively disciplined on a rate hike as soon as September and no later than December, barring an unexpected downturn.
There is unlikely to be a radical break from current orthodoxy as the FOMC remains committed to the policy normalization of gradually and cautiously raising interest rates.
Jeremy Stein’s paper on the merits of the Fed maintaining a large balance sheet to foster financial stability may prove to be the most influential of the presented academic papers.
August 29, 2016
Two themes stood out for us by the time the Federal Reserve Bank of Kansas City conference in Jackson Hole wrapped up this weekend:
*** The first was how consistent the comments were by Chair Janet Yellen and her Federal Open Market Committee colleagues in steering market expectations to the likelihood of a rate rise before year-end and as soon as their September 20-21 meeting. The impressively disciplined messaging now puts the focus on the upcoming data over the coming weeks, this Friday’s Non-Farm Payroll in particular. ***
*** And second, in asserting the “new” policy tools of interest on reserves, QE, and forward guidance should be enough to complement rates policy in tackling a downturn, Chair Yellen was also acknowledging there will be no return to a sole reliance on the pre-crisis toolkit. Likewise, despite a seeming dismissal of more radical policy tools as “subjects for research,” we doubt she was ruling out departures from orthodoxy if the current policy mix should come up short. ***
*** Indeed, we suspect the paper by former Fed governor Jeremy Stein on the merits of maintaining a large balance sheet may prove to be among the more influential Jackson Hole papers in recent years. In any case, it points to the likelihood that balance sheet policy will be at the forefront of Fed policy discussions at some point next year whatever the pace of rates normalization, and especially if a new President and Congress put fiscal policy back into play. ***
“A Serious Discussion”
In her opening remarks, Fed Chair Yellen said the case for a rate hike was “strengthening,” though she carefully skirted its timing, which we rather expected (SGH 8/25/16, “Fed: Desperately Seeking Clarity”). Instead, the messaging for a hike as soon as September was delivered by Vice Chair Stan Fischer and other Committee colleagues like Atlanta Fed President Dennis Lockhart, who said “a serious discussion” for a rate hike at the September meeting would be warranted if the data delivers in the coming weeks.
The messaging discipline on a coming rate hike was especially striking in that the still skeptical FOMC members like Governor Lael Brainard, who also attended the Jackson Hole conference, chose not to speak to the press. Likewise, most of the FOMC stuck to the “every meeting is live’ mantra, even though most of the market believes it is eroding the Fed’s credibility rather than its own complacency about a nearing rate hike.
That said, the market’s September probabilities pricing snapped higher after Fischer’s remarks and seems likely to stay above or go higher with this morning’s decent personal consumption print. Anything near or edging above the 50% mark would be fine by the Fed with a few weeks still to go before the September meeting.
And the recent data, especially the 190,000 three month average job creation, does point to a modestly greater case for a second rate tightening in what is, after all, likely to be an extremely gradual ascent in the policy target range. Even the somewhat weak 1.1% second quarter GDP data — which the Fed pays less attention to compared to the monthly NFP — probably understates the pace of economic activity compared to ex-inventory real final sales, a more reliable indicator. This morning’s personal consumption only adds to the rate hike narrative.
We were nevertheless a little surprised by how much Fed officials elevated the importance of a single data point like Friday’s NFP in light of the miscue that came with the May jobs numbers that was later reversed in the succeeding two NFP prints.
It is highly likely the pace of job creation will stay in line with the base case forecast for a steady tightening in the labor market, but the component breakdowns, especially in the wage indicators like the hours worked, the length of the work week, and the participation rate, may not necessarily close the case for a rate hike as soon as the September meeting.
At this point, however, our sense is that the FOMC consensus for a second rate hike in the long gradual ascent of rates in the policy normalization framework has essentially been in place since early summer. It was delayed but not derailed by the May NFP miscue and the return of Brexit-led global risk management concerns.
So barring a sharp shock or southern slippage in the data in the coming weeks or forecast through next year, this remains a Yellen-led FOMC that is looking for its tactical moment to raise rates this year, to be followed by a likely extended pause (SGH 8/26/16, “Fed: A More Certain Rate Hike by Year-End”).
No Radical Departure from Orthodoxy
In terms of the longer range issues facing monetary policy that was the main topic of the Jackson Hole conference, we were a little surprised Chair Yellen did not venture a little more forcefully into the merits of potential departures or at least tweaks to the current policy and forecasting assumptions in her keynote speech that was after all meant to introduce the theme of building more resilient policy frameworks for the future.
In hindsight, however, that is probably not in the job description for the Chair of a such a conservative, consensus-driven institution like the Fed. A central bank policy framework is called “orthodoxy” for a reason. And aside from former Fed Chair Paul Volcker’s sudden but brief embrace of monetarism in 1979, change in the Fed policy framework is evolutionary with tweaks and adjustments to parameters or a new equation inserted into the forecasting model rather than a sweeping, radical flight from the existing policy regime.
But in asserting that the post-crisis “unconventional” policy tools like paying interest on reserves, large scale asset purchases, and forward policy guidance are now conventional and potentially enough to cope with the next downturn, Chair Yellen was in effect acknowledging things will never go back to the pre-2007 era of small scale open market operations and discount window access for the occasional commercial bank in distress.
The Rubicon in wading beyond new policy frameworks as “subjects for research” was in fact already crossed in June. That was when Chair Yellen on behalf of the the FOMC all but conceded its previous assumptions of a slowly rising neutral policy rate and the temporary headwinds restraining it were being tossed to the side, and that the FOMC was embracing instead a belated recognition a near zero real equilibrium rate was likely to persist for far longer than previously imagined (SGH 6/15/16, “Fed: Redefining Gradual”).
It is likewise not impossible to imagine this Fed embracing still new “unconventional” policy tools if the current now conventional mix of policy instruments falls short in an economy that just can’t lift itself out of what St. Louis Fed President Jim Bullard describes as a low productivity, low growth, low interest rate, multiple state regime.
Stein’s Large Balance Sheet Scenario
On that note, and as a last takeaway from the Jackson Hole conference, we were struck by how influentual the academic paper presented by Jeremy Stein, the former Fed governor, and two of his Harvard colleagues, may prove to be.
In the paper, “The Federal Reserve’s Balance Sheet as a Financial-Stability Tool,” Stein seemed to be building on his previous work on the ways that the Fed can complement its monetary policy to help to sustain financial stabilty. In this case, instead of the Fed’s stated intention to eventually cease its reinvestments and roll off its portfolio of treasuries and mortgage backed securities to somewhere near a still unspecified pre-crisis size of the balance sheet, Stein and his Harvard colleagues made the case the Fed should maintain an enlarged balance sheet.
The Fed could then use its portfolio of treasuries to help satisfy the market’s massive demand for safe assets, by expanding the supply of overnight reverse repurchase agreements to the market with the Fed as the market counterparty, which would essentially provide the same function as a boost in the Treasury’s debt management issuance of treasury bills.
In doing so, the Fed could help maintain financial stability by reducing the private market’s creation of synthetic safe assets or undertaking excessive amount of maturity transformation outside the banking system that has and could again come to grief in systemic problems down the road.
While there are a host of larger mandate and political issues in Stein’s proposals, we suspect a more activist use of the balance sheet as a policy tool will be coming to the forefront of the Fed’s policy discussions before too long.
That day would come should the Fed ever undertake another large-scale asset purchase program, even under Chair Yellen’s restrained embrace of another LSAP if necessary.
And we expect it may be as soon as next year when the role of monetary policy in relation to fiscal policy will have to be considered if there is a major boost to federal discretionary spending fiscal policy, which we think likely under a new Administration and Congress (see SGH 5/6/16, “US Politics: The Fiscal Accelerator”).