With little need to debate the prospect for a rate move at their two-day meeting this week, the Federal Open Market Committee will instead delve into three broader but intertwined issues. And how Fed Chairman Jerome Powell addresses them in his post-meeting presser will both set the immediate market reaction and go a long way to shaping market expectations through the first half of the year.
*** The first, which we suspect will also be the first question to Chairman Powell at the presser, will be on the balance sheet expansion and asset prices. Fed officials are fully aware of a firmly entrenched market narrative of a “QE rocket fuel” to asset prices in the central bank’s bill purchases and repurchase agreement operations. The Committee still intends to wind down the bill purchases beginning sometime this spring as the optimal level of reserve balances nears. But sensitivity to the risk of market dislocation is likely to translate into a tapering of the bill purchases, while Chairman Powell will be careful to avoid the messaging misfire of December 2018 by acknowledging its impact on market sentiment even as he stresses the policy neutral nature of the asset purchases intended to add a stable cushion of reserves. ***
*** The FOMC is also likely to discuss what a “material reassessment” to the base case forecast that could lead to a rate move would entail. While we doubt the phrase will make its way into the formal statement – a consensus to define it more explicitly would be difficult — we suspect Chairman Powell will lay out a very asymmetrical reaction function going forward when addressing the issue on Wednesday: slow to react to upside surprises without “persistent” upward momentum to inflation, and a fairly quick, downside risk management-driven easing on the earliest signs of sagging growth or falling inflation. Even without signs of recession – that would presumably bring rates quickly down to the Zero Lower Bound – growth below trend or falling inflation expectations would probably warrant a modest easing. ***
*** Both issues come into play in the next leg of the policy framework review. The FOMC seems to be narrowing its discussions to modest consensus language changes to the inflation mandate, to emphasize how truly symmetrical the 2% inflation target will be to the timing and pace of a future tightening cycle. The eventual tweaks to the Statement on Longer-Run Goals and Monetary Policy Strategy may in the end be relatively minor, but their dovish policy signaling will not be, and the messaging may prove tricky to navigate. Many Committee members, for instance, want to more clearly address how an extended period of low rates could drive asset price inflation, while the narrow framework focus could unsettle markets looking for grander, more muscular policy conclusions when the review is unveiled in June. ***
Winding Down Asset Purchases
While it seems unlikely there will be any changes to the Fed’s current balance sheet expansion strategy, Powell is likely to use his post-meeting press conference to stress the Fed’s balance sheet management policy is solely being driven by the need to bring excess reserves back to a higher than projected equilibrium level to satisfy bank demand for reserves. From the Fed’s perspective, if the banks want more liquid reserves as the optimal, most prized high-quality liquid assets to meet liquidity ratio requirements or as prudent risk management, is that a bad thing? Indeed, it was a key reason for the decision a year ago to embrace the “ample reserves” policy.
With so much market focus on the balance sheet expansion, we suspect the Chairman may put a ballpark number on a likely eventual size of the balance sheet on Wednesday, even if a final decision on the terminal point may not come until the March meeting. For now, it seems the target equilibrium reserve level will probably end up north of $1.6 trillion, essentially back to pre-September reserve levels (without the repo totals) as something of a floor level, with an extra dollop of reserves added to the eventual target to reflect organic growth in currency demand, and an additional layer to cushion against the volatility in non-reserve liabilities like the Treasury’s General Account or the Foreign Repo Pool.
In light of the market’s heightened risk-on appetite in response to the Fed’s asset purchases and repo operations, the Chairman and his Committee colleagues would do well to brush up on “attractive nuisance” laws: a property owner, as the most common example, has built a swimming pool on his property strictly for his private use, replete with a fence and no trespassing signs; but under the so-called attractive nuisance laws, he is still liable and responsible if the neighborhood kids take to a different interpretation of his intentions with that big appealing pool of water.
“Attractive nuisance” has in fact been a metaphor kicked around the Board on regulatory and supervisory matters, and it could also provide a useful description of how the FOMC can square the circle of unintended consequences between what it insists is a technical, policy-neutral fix to the financial system plumbing and the market’s assessment of the balance sheet expansion as little more than an Olympic-sized swimming pool of QE liquidity quenching the thirst for risk assets.
So like the swimming pool owner, if the Fed’s balance sheet expansion nevertheless encourages a stronger appetite to buy stocks or to take on more risk, it doesn’t really matter what the Fed says about the reserve management: asset prices will go higher and the Fed is effectively liable for its consequences, however unintended. It is the reality finally acknowledged by Federal Reserve Bank of Dallas President Robert Kaplan before the pre-meeting blackout.
A Counter QE Communications Campaign
To push back against the market’s QE rocket fuel assumptions, Chairman Powell is very likely to use his remarks on Wednesday to press a counter narrative in the hopes of lessening the risks of market dislocation – and the Fed’s nuisance accountability. It will mark the start to a concerted communications campaign by Fed officials through the spring to drive the point home that the Fed balance sheet policy is not the sole or even a primary driver to the rise in asset prices since October, but at the same time, to avoid a messaging misfire in a repeat of the December 2018 “auto pilot” remark, he is likely to acknowledge the balance sheet expansion nevertheless does seem to help support investor perceptions and confidence.
But Powell may nevertheless press the Fed’s belief there is no “more money” being created to buy stocks in the Fed’s withdrawing treasury bills from private sector balance sheets and replacing them with bank reserves – government liabilities for central bank liabilities — nor is there any explicit link between the Fed’s bill purchases and driving the sellers of the treasury bills into riskier assets, in large part because there is no policy-driven downward push on the term premium through the “portfolio rebalancing” channel of the prior QE programs that were concentrated on longer tenor treasuries.
And Chairman Powell will also undoubtedly make the case as other Fed officials have of a mistaken causation for correlation between the bill purchases and higher asset prices and valuations with last year’s rate cuts, the easing of trade tensions, and better growth prospects that have nearly extinguished recession fears.
In addition, to help bolster the messaging effort to lessen dislocation risk, it is likely the FOMC will opt to taper the wind down in asset purchases in two or three steps, from the current $60 billion a month to, for instance, either $30 billion or $20 billion over several months, probably stretching the shrinking asset purchases a bit into the second half of the year. Even if the decision is not made this week, assuming the reserve balances hit the $1.6 trillion mark next month, the FOMC should be in the position to announce the tapering program at the March meeting.
In the meantime, we have no reason to doubt the high expectations the Interest on Excess Reserves and the overnight reverse repo rate will be both raised by 5 basis point each on Wednesday to 1.60% and 1.50% respectively. At least on this front, there are few, if any, who would misinterpret the tweak as a tightening.
An Asymmetrical Reaction Function
There is some sense the Committee may discuss whether to put a reference into this week’s formal statement to the “material reassessment” phrasing Chairman Powell had introduced in October, as a powerful signaling of the Fed’s present “high pressure” policy leanings. But for now at least, it seems unlikely so soon after the “the current stance of monetary policy is appropriate” language was brought into the December statement language and in any case, crafting a consensus on how exactly to define a “material assessment” may prove to be next to impossible.
Notwithstanding the new uncertainties of the Chinese coronavirus that surfaced too recently to alter the forecasting preparations for this week’s FOMC meeting, there is still a fair degree of cautious optimism for an economy in a good place with the tailwinds of last year’s rate cuts and the easing trade tensions bolstering the base case outlook for continued above-trend growth, a still slowly tightening labor market and, perhaps even more optimistically, a modest slight rise in inflation expectations if not actual inflation through the year.
We did not get any sense before the pre-meeting blackout that Fed officials are too worried by the surprisingly weak wage growth in the most recent Non-Farm Payrolls print. It would take several months of similar downside surprises to the data to garner more than a raised eyebrow, though there is a cautious eye on Friday’s quarterly Employment Cost Index for clearer signals of any weakening, as it is a better indicator of underlying trends.
However vague Chairman Powell and Fed officials choose to keep their sense of what would constitute a “material assessment to the forecast, its use as a repeated mantra underscores the extent to which a pretty asymmetrical reaction function is driving the Fed rate policy stance in a near term that could easily extend well into next year.
Since there looks to be only a very limited probability to an upside inflation surprise – and if there was, it would almost be welcomed at this point – the far higher probability to any reassessment is going to be to the downside. But in some sense, the near-term scenario most feared by Fed officials is not so much a sudden lurch towards recession – it would almost certainly trigger the “rapid and swift” cuts in rates back to the Zero Lower Bound under the so-called Reifschneider-Williams playbook – but rather an even more problematic slow ebbing in the economy’s already tepid momentum, with growth perhaps slipping back below an already low trend estimate, or perhaps even worse, inflation failing to rise or even slipping lower along with eroding inflation expectations.
Cyclically falling short run r* estimates would in all likelihood be enough to hit the mark for that “material reassessment” of the forecast, triggering a modest rate cut with the limited rate space left to the Fed with the policy rate already brought down last year to 1.5%-1.75%. How to message a rate cut as an adjustment rather than the first step towards the ZLB and QE – in an election year – will be a challenge, to say the least.