Two key intended takeaways seem likely in the Federal Open Market Committee’s policy messaging this Wednesday. The trick will be how to smoothly and clearly communicate them in the mix between the statement language and Federal Reserve Chairman Jerome Powell’s first of the new press conferences after every FOMC meeting:
*** On rates, the FOMC will seek to convey the “patient pause.” Muted inflation and rates at or very near neutral afford the Fed flexibility over the coming months to assess underlying trends in the data. But since the Fed does not share the market gloom over the outlook, we believe the Committee will not be willing yet to jettison its upward rates bias. On balance, we suspect the wordsmithing choice will be to retain the upward bias in the statement’s guidance but to add they will be “patient” in “judging” whether “some further gradual” rate increases would be appropriate. ***
*** Opting to retain the statement guidance for at least a few more meetings may complicate the messaging down the road, especially if there is a near upside inflation shock, while the progression since last March has been a gradual exit from formal statement guidance. But our sense is a desire to avoid any potential whipsaw risk in leaving the heavy lift on the patience messaging entirely to Powell thirty minutes after the statement. And in any case, the Chairman may have his hands full on the conveying the nuances to the balance sheet policy. ***
*** And on the balance sheet, we think Powell will signpost the FOMC’s progress towards the eventual operating framework and optimal level of reserves. He will stress that any “slowing down” or taper being considered in the pace of asset run-offs will be technically driven to determine the minimum level of reserves necessary for the efficient execution of monetary policy. The balance sheet will not be used in the near term as a policy tool, and any response to any balance sheet tightening will be taken through rates, not the assets running off, even if markets should choose to interpret it otherwise. ***
Balance Sheet “Flexibility”
Since the FOMC is neither moving rates this week or announcing a final decision on the balance sheet, almost all of the market attention will be on Powell’s every last careful wording and phrasing in his post-meeting press conference, especially in the wake of some messaging misfires over the last few months (see SGH 1/18/19, “Fed: “Powell Risk”).
We suspect his message on the balance sheet may prove to be the most problematic, but his intended takeaway will rest on two points:
First, we think it is possible he may affirm that the balance sheet discussions this week did include further consideration of some adjustment or “tapering” in the pace of the assets run-off, but that; second and tightly linked to the first, the eventual size and composition or any tapering in the pace of shrinkage in the Fed’s securities portfolio will be driven entirely by technical not policy considerations.
That the FOMC was contemplating the merits of a taper in the pace of the current $50 billion a month in asset run offs, presumably by a downward adjustment in the treasuries cap, was the one tidbit of detail that leapt out to us from the December meeting Minutes.
As we have written previously (see SGH 1/25/19, “Fed: The January Balance Sheet Debate,” and SGH 12/21/18, “Fed: The Balance Sheet Question”), few if any Fed officials or staff believe shrinkage by some $600 billion in excess reserves in the banking system since the balance sheet roll off began in October of 2017 has had but the most minor of effects on market conditions and market liquidity.
But on the other hand, if truth be told, many if not most Fed officials concede they are nevertheless uncertain of the balance sheet effects, or of any potential signaling effects, even if they have methodically steered clear of explicitly linking a shrinking balance sheet to the tightening effects of higher policy rates.
In his Wednesday presser, we suspect Powell may push a little harder in stressing how any adjustment in the pace of the balance sheet run-off, if taken, would be driven by a technical calculation to lengthen the runway in right-sizing the optimal level of reserves needed in the banking system for the efficient execution of monetary policy. It was only a year or two ago that there was an internal assumption of $500 billion as the optimal level of reserves; these days our sense of the internal deliberations would put that figure much higher to either side of $1 trillion.
Our sense of the progress in the FOMC’s balance sheet deliberations would point to the March meeting for the first possible release of a revision to the June 2017 balance sheet “Principles and Plans.” Along the same lines, we do not expect the balance sheet to get a mention in the formal January statement, nor in the annual review of the “Statement on Longer-Run Goals and Monetary Policy Strategy.”
To be sure, the FOMC has surprised in the past on how quickly they were able to move on balance sheet decisions, but we suspect Powell will strive to avoid being too specific on the current deliberations to maximize the running room for the FOMC’s discussions going forward and, if for any other reason, to avoid front running the January meeting Minutes.
Rates “Patience” Afforded by Muted Inflation
The reaffirmation of the patient pause on rates that has been such a constant anchor to the policy messaging over the last few weeks, on the other hand, should be fairly easy to get across by the time Powell leaves the stage on Wednesday afternoon.
The only issue is tactical, whether to do it primarily through tweaks in the statement language or to get out of the guidance business altogether as the FOMC has been trying to do ever since Powell’s first meeting as Chairman last March.
On first instinct, the path of least resistance with this Wednesday’s messaging may be to tweak the statement, continuing with the formal guidance of “some further rate increases” but softening its gawkiness with the language the FOMC can afford to be patient.
That, however, may complicate the messaging down the road, especially if the economy or especially inflation harshly surprises to the upside; the new guidance language could then need to be stripped back out in several steps, limiting the very flexibility the FOMC seeks so badly.
On balance, then, it might prove easier to just get out of the formal guidance while they can, and to hope for the best in Powell finding a careful balance in conveying the patience but steering clear of letting it go too far in deepening the market’s desire for an explicit signal to an end to further rate hikes.
But beyond Wednesday’s messaging, and whether it goes smoothly or is met with another undesired bout of volatility, it is clear the FOMC is hardly as gloomy on the outlook as many are in the markets. And while US growth is slowing, it was expected and needed to be slowing as the fiscal stimulus fades. What’s more, the slower global growth at this point will only add to the sense of a bit more downside risk rather than a clear downgrade to the outlook.
And above all, the FOMC and staff are still intensively debating the evolution in inflation dynamics, trying to decipher how and why inflation has remained so persistently inertial despite the tightness in the labor market, a point we have noted through much of last year (see SGH 12/19/18, “Fed: The Persistence in Low Inflation”).
Even the more hawkishly-inclined Committee members seem to be taking note of absence of expected upward price pressures. And that no-show, barring an upside shock in the inflation measures in the coming months, is all but ensuring the solid Committee consensus they can afford to wait, or be patient, on any further rate hikes, if any at all.