Fed: Looking to September

Published on July 1, 2016
SGH Insight
It is September that is now shaping up to be the pivotal meeting. There may be enough clarity in the data and in market conditions to either proceed with that elusive second rate hike in the policy normalization path — not impossible despite the low odds — or to signal a shift to a neutral or even an easing policy stance. Despite the market pricing, the latter is not the Fed’s base case.
Market Validation
(FT 8/28/16) European bond yields crept higher and stocks across the continent slipped in trading thinned by a holiday in the UK, as investors digested the message delivered late last week by Federal Reserve chair Janet Yellen that the case for rise in the central bank’s key short-term interest rate has strengthened.

The remarks delivered by Ms Yellen at a gathering of central bankers in Jackson Hole, Wyoming, have been enough to pull higher the probability traders attach to policymakers lifting borrowing costs when they meet next month to 42 per cent, up from below 30 per cent before she spoke late on Friday.

Key Takeaways:

The Federal Reserve is in a “watchful waiting” mode to weigh how the data and Brexit effects play out through at least the summer.

A rate move at the FOMC’s September meeting cannot be ruled out if the economy stays on course, but a renewed run of dollar strength would limit its odds considerably.

Ebbing growth or dampened inflation would trigger an easing sequence with an end to the tightening bias, rate projection downgrades, a rate cut, and a shift to balance sheet policy, starting with a Twist operation.

For a Federal Open Market Committee that had already turned more cautious at its June meeting, the volatility and uncertainties in the wake of the stunning Brexit vote could hardly have come at a less ideal moment. At least in hindsight, the hesitation last month on the well telegraphed intention to raise rates this summer could prove fortunate if there is a southerly turn in the outlook in the coming months.

*** Even before Brexit, the FOMC was already hunkering down into a wary “watchful waiting” mode to see how the data plays out through the summer in either signaling a still tightening labor market or an ebbing momentum. The probabilities, now laced with Brexit uncertainties, may modestly be tipping towards the latter. Next week’s Non-Farm Payroll is expected to revert back to an upward trend, but the Fed is watching for a sustained dollar appreciation that could again dampen long-sought upward inflation. ***

*** The July FOMC meeting is “live” in the sense of a possible end to the bias to tighten if the data falters. But it is September that is now shaping up to be the pivotal meeting. There may be enough clarity in the data and in market conditions to either proceed with that elusive second rate hike in the policy normalization path — not impossible despite the low odds — or to signal a shift to a neutral or even an easing policy stance. Despite the market pricing, the latter is not the Fed’s base case. ***

*** But if the economy should be slipping south, the FOMC is likely to move to a sequence of easing measures, starting with dovish guidance language, reinforced by another downward lurch in the quarterly rate projections and a lower neutral rate estimate (which is likely anyway). A cut in the fed funds target would be followed by a review of the Fed’s balance sheet options, with a repeat of the Average Maturity Extension program the policy option of first choice. ***

It has to be said that at least for now, however, the downside risks, however elevated by the Brexit vote, are still risks, not realities forcefully tugging down on the forecast. Indeed, the higher odds are probably still for an “extended” pause — perhaps a full year from last December’s rates lift-off — in the pace of interest rate increases rather than an abandonment of the policy normalization consensus that has been so laboriously forged in a Committee that is resistant to wholesale changes in policy regimes.

Brexit Aftershocks

Federal Reserve Chair Janet Yellen has rarely missed the opportunity in her recent speeches and remarks to stress the elevated degree of uncertainty that now hangs over the Fed’s policy calculations. In what feels like ages ago, for instance, she noted in the June press conference the uncertainty over the strength of the labor market, and now with the self-inflicted shock of the Brexit vote, the uncertainly, well, over just about everything.

Yellen’s colleague and consistent ally on the Board, Governor Jay Powell, picked up on that theme, adding an accent or two in an important speech earlier this week that reflects the views of the Chair and a probable Committee majority.

First, Powell made a point — in stark contrast to the nearly exact opposite emphasis in a speech last May — to again note the uncertainty over the jobs outlook and the need to see the labor market data over the next few months to better discern any shift away from the assumed tightening trend. Renewed global risks have added to the downside risks that were already seeping into the most recent weak to at best mixed NFP print. While job growth was in fact expected to be slowing through this year, such a sharp drop in a single month was enough to garner scrutiny.

And without the confidence in a still tightening labor market — and it is a low bar these days with anything above perhaps 100,000 jobs a month still translating into a further mopping up of labor market slack — the ability of the Fed to look through the recent output growth fluctuations would become problematic if not imprudent.

And now, the Brexit shock may portend another ascent in the dollar and the bout of export weakness and renewed downward pressure on goods inflation. The dollar has not climbed all that much just yet, and markets at least for now may have stabilized, but a steady bid under the dollar may be enough to alter the Fed’s growth and inflation forecasts just enough to push rate hikes even further out an already increasingly distant horizon.

That scenario fits neatly into the second theme Powell noted, namely that the Fed’s rate projections in the outer years of the Summary of Economic Projections rate plots as well as the longer run neutral policy rate estimates are both all but certain to be marked down again, probably as soon as the September rate dot plots.

In particular, not only is the Fed conceding the lower rate projections the market has already been pricing in for what seems like ages, but importantly, Chair Yellen made remarkable concessions on the structural drivers to an equilibrium real interest rate that now seems likely to stubbornly persist at or near zero for much longer than the majority of the Fed was generally assuming as little as a few months ago.

That no doubt accounted for some of the somber tone to Chair Yellen’s June meeting press remarks, and which is likely to be laced through the June meeting Minutes when they are released next week.

The South-Bound Policy Sequence

If — and that is a not insignificant caveat at this point — the pace of economic activity does indeed look to be slipping south towards stall speed or worse, the FOMC will be fairly quick to backpedal into a defensive policy stance. As the Yellen-led Fed has repeatedly shown, cautious prudence when so close to the Zero Lower Bound invariably translates into an instinctive pullback.

The cornerstone “sooner and slower” thesis to the policy normalization strategy would be giving way, not to “later and faster” as was the original juxtaposition, but to “later and slower still,” if not to a reversal in gears altogether, with the “Plan B” Playbook being dusted off.

The likely sequence of easing would begin with the Committee’s bias to tighten giving way to a more neutral reading statement and potentially the re-assertion of the balance of risk assessment which, in this case, would be to the downside. Depending on the data, that could come as soon as July.

But September is likely the pivotal meeting for an FOMC that could find itself at a policy crossroads. By then, it is hoped data and market financial conditions will allow the Committee to either reaffirm its commitment to the policy normalization path of ever so gradually raising rates, or in the case of downside risks becoming a reality in faltering growth, to shift into a safeguard of renewed easing.

The more explicit dovish signals in the statement and policy language would be reinforced by what is all but certain to to be a further reduction in the rate dot projections across the three year forecasting period, as well as another mark down in the estimates for the longer run neutral rate in the September rate dot plots. That, in fact, is coming even if the near term outlook holds out against the uncertainty and looks to be staying the course of that still steadily tightening labor market.

The obvious next step would be a reversal in the December rate lift-off right back to the 0 to 25 basis point target range for the federal funds rate that had been in place for seven long years. The next step would be a shift in the stance on balance sheet policy.

A return to a major Large Scale Asset Purchase program, however, is unlikely to be the balance sheet policy option of first call. Our sense is that the FOMC would tend towards another Average Maturity Extension, or Twist, selling the shorter term paper in the portfolio with a maturity under three years and buying longer treasuries with maturities of at least seven years or longer. The intention, or hope, would be to offset any dollar tightening effects on financial conditions, and with a little luck, it would lead to lower corporate spreads, not to mention a boost in confidence in the real economy.

It is, however, far, far too soon to speculate on such a step or which bonds might be up for grabs or for sale. It is a step, it is safe to say, the Fed would not be looking forward to taking. The hope, and prayer, by then would rather be for a post-election political consensus to undertake a major fiscal stimulus to finally lift the burden off monetary policy as the sole means of stoking and sustaining a recovery

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