Fed: Looking Past Dovish Tone to the Minutes

Published on July 8, 2015

It is probably worth noting that market could take a dovish read to the Federal Open Market Committee’s June 16-17 meeting Minutes released later today. That is especially the case coming amid the heightened uncertainty on the international front, be it China or, of course, the ongoing saga over Greece.

*** We still believe the FOMC majority continues to move towards a consensus for a “sooner rather than later” start to policy normalization, with a first rate hike in September and the adjustments to economic developments in the pace of the subsequent hikes. The data since the June meeting — including last week’s Non-Farm Payroll that we doubt the Fed took as dovishly as the market seems to have — still points to a 2.5% or better post-first quarter pace of growth the Committee feels is the “decisive” evidence of employment and forecasted inflation moving towards mandate-consistent levels. ***

*** That said, however, there are obvious risks to this base case outlook, which the FOMC is likely to have debated extensively in their June meeting, and which will likely stand out to jittery markets, with Greece looming largest. But as we noted earlier (SGH 7/2/15, “Fed: The NFP, and the Greek Question”), the continued overhang of risk of Greek contagion spilling over into the US forecast will not deter the Fed from its base case for a rate hike in September, it would be the reality of turbulence from a “Grexit” that would indeed likely cause a delay due to its transmission into US growth downgrades and especially the likely renewed downward pressures on US core inflation. ***

Debate over the Outlook, Especially Inflation 

The first dovish take from the Minutes may be a debate over the growth outlook. A tone of caution might run between the lines of the discussion over the near term outlook on growth, for instance, reflected in the first paragraph of the statement that, though more upbeat about the economy than the April statement, was still sprinkled with subdued language about the economy expanding “moderately,” housing showing “some” improvement, or that business investment and net exports “stayed soft.”

It has to be said, however, that the Committee consensus by the latter part of the “decision” section of the Minutes will likely be to reaffirm a forecast for a post-first quarter rebound. And the data since the meeting has been to the stronger side of the 2.5% pace of growth several Fed officials have suggested is the “decisive” evidence needed for the FOMC to conclude both growth and the inflation forecast will warrant the start to policy normalization “later this year.”

A greater Fed caution that may emerge lies in what was likely to be a discussion over how certain the Committee can be about core inflation moving up from its current inertial levels of 1.2%-1.4% any time soon. The risk remains in the minds of at least an influential minority of the Committee that with core inflation still so persistently low, a premature rates move could slow the recovery to below trend growth or worse, and could push inflation even lower to prolong the unwelcome stay at the Zero Lower Bound.

We also suspect that the inflation question was probably a key driver to those “core centrists” moving their two dots down to one in the dot chart.

But as we noted at that time (see SGH 6/17/15, “Fed: The Dot Compression is Key”), we suspect the nudge down to a single rate hike this year wasn’t necessarily saying much about the timing to a first rate hike per se; instead it reflected a general sense of the appropriate level of initial tightening needed this year, and could have easily been a reflection of a caution for a second hike before year-end rather than deepening doubts over first rate hike in September.

We also think that this appropriate level of interest rates will be revised to the data, with most of the “one dotters” nudging their rate projections back to two dots, assuming of course the key data points continue to be as good as expected from here.

And key to the inflation forecast is an ongoing faith in a Phillips Curve linkage between employment being pushed through its longer run levels, or NAIRU, and broad-based upward pressures on wages triggering a cost-push on core inflation in due course.

While the timeline to those linkages could be stretched beyond the current assumptions for that upward pressure showing up in the data on a sustained basis by the turn of this year and into the first half of next year, the direction will nevertheless be clear and it will still warrant the start to the very gradual removal of monetary accommodation.

And, of course, Greece

The third of the potentially dovish takeaways from the Minutes, and the one that looms largest, is what was inevitably a lot of discussion about the potential for the Greek crisis to spill over into the US. Chair Janet Yellen acknowledged that risk in her post-meeting press conference, and several FOMC members also noted Greece and its potential consequences in subsequent remarks and speeches as a downside risk — and that was before the referendum gambit of Greek Prime Minister Alexis Tsipras and the gathering gloom over a Greek resolution.

Our sense is still that a Committee majority still believe the data will continue to point towards that “decisive” 2.5% or so pace of growth in the economic rebound since the first quarter stall speed which, in turn, will continue to tighten the labor markets enough to put upward pressure on wages. It seems unlikely there will be all that much firm evidence of higher wage pressures much before the end of this year, but we do think the Committee majority will still be “reasonably confident” for a steady upward movement in core inflation at some point next year to warrant a first rate hike in September.

All that said, if Greece does implode, it is likely to delay a first rate move as the international disinflationary pressures and the stronger dollar would, more than anything, crush any sense of core inflation rising by this time next year. Those expected upward wage pressures on services inflation, assuming they do show up in the data by the end of this year into early next, probably wouldn’t be enough on their own to lift core inflation next year without the projected absence of the downward pressure on goods prices of the strong dollar.

But as we caution, for now, there is only a risk of Greek spillover, not a reality, and since Europe has years of structural problems to deal with, the risk alone is highly unlikely to deter the Fed from its long-sought start to policy normalization later this year.

And there is Yellen on Friday

As an added aside, the overhang of the Greek crisis may also limit how far Chair Yellen can go in her remarks on the economy this coming Friday. The speech is something of a preview to her Humphrey Hawkins testimony next Wednesday before the usually combative House Financial Services Committee. We think her question time may be taken up with the usual complaints and needling questions on bank regulation or the ongoing saga over the alleged leaks of confidential information, but she is likely to give a fairly optimistic take on the economic outlook and a nearing start to policy normalization, albeit with plenty of acknowledgement to near horizon risks.

She in any case may not want to venture much beyond the current “data dependent” messaging framework, the cloud of Greece notwithstanding, until an assumed stronger-looking data comes in through the rest of this month and August.

In some sense, until we get much closer to the September meeting, the Fed would love the market to price to the data instead of signals from Committee members or certainly the Chair herself, which may be why she shied away from giving the keynote address at this year’s late August Federal Reserve Bank of Kansas City conference at Jackson Hole.

And in that way, it would be a sign of the market “normalizing” in parallel to a policy normalization that would, to some degree perhaps, allow the Fed’s first rate hike to “follow” the market’s lead rather than grabbing it by the throat to shake out a more turbulent re-pricing to greet a first rate hike. Good luck on that, but it is a much-prized objective anyway

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