Fed: March Preview

Published on March 18, 2019

With no rate changes on the table seemingly for as far as the eye can see, most of the market focus on this Wednesday’s wrap on the Federal Open Market Committee March meeting looks will be on the median 2019 rate dot projections and the expected statement confirming an end to the balance sheet run-off later this year.

*** On the rate dot plot, we expect the 2019 rate median to show an unusually strong Committee consensus coalescing around one hike this year, down from the two in December last year and three in September. We would be very surprised if the median drops all the way to zero hikes. The median base case rate path is very likely to flatten considerably but still show a modest upward trajectory across the three year forecasting horizon. The longer run neutral estimate, certainly in the fuller ranges if not in the median, could also slip lower again. ***

*** In the Summary of Economic Projections, we don’t expect much to change beyond perhaps a modest downward tweak in real growth for this year. First glimpses of how much the Fed is adopting its forecasting assumptions to its still evolving sense of inflation dynamics may come in a lowered longer run neutral estimates for unemployment and perhaps a slight upward tweak in trend growth. We will be especially watching for whether an extended “patient pause” this year will allow for an overshoot to be penciled back into the later years of the core PCE projections. ***

*** On the balance sheet, the Committee is very likely to affirm an end to the asset run-off this year, probably by October. We doubt it will come sooner, in June for instance, and though possible, we likewise doubt June will see a tapering in the monthly caps. The FOMC may also map out a two step process to an eventual equilibrium reserve level around $1.1 trillion, allowing reserves to be more naturally extinguished as other liabilities rise through next year. We suspect the FOMC hasn’t decided yet on the portfolio’s eventual average maturity. ***

Downward Rate Shifts 

In the wake of the capitulation of the inflation hawks that became so starkly evident by the time of the January meeting (see SGH 1/30/19, “Fed: Throwing in the Towel”), we suspect the first of the quarterly rate dot projections this year will show a pretty sizable compression for 2019 and across the full three years of the forecasts.

We would not be surprised if more than half of 17 Committee members mark their assumed base case rate path for this year down to a single rate hike, while four or more may mark none and only a few if any still penciling in two hikes this year. It would be a fairly remarkable downward adjustment in the appropriate rate assumptions.

Driving the lower rate projections is, of course, the near-demise to the long reign of the labor slack-based Phillips Curve as the primary driver in the Fed’s modeling of inflation dynamics in favor of inflation expectations. But we doubt the now accepted likelihood in the persistence in low inflation will translate into all rate hikes being brushed out of the Fed’s rate picture, for several reasons:

The first is that such a steep drop in the assumed rate trajectory going into so many the forecasts by the Board and 12 districts staffs just doesn’t feel realistic to us when the overall growth projections are unlikely to be changed all that much, certainly not in any sort of deep downshift from December 2.3% real growth median projection.

Growth is by all means expected to slow, but no one across the Fed system from what we gather is pointing to higher probabilities for recession, if for any other reason, the Fed’s own sharp pivot in January from its December meeting essentially removed the risk of a Fed policy error in tightening by too much or too soon.

The second is the nature of the forecasting process itself and the assumptions going into the rate projections: even if growth slows this year as expected, an ongoing above trend growth almost by definition would entail a modest rise in the short run r* estimates. Penciling a rate hike into the forecast, in other words, would be considered appropriate just to stay at neutral, even if the projections didn’t presume a further tightening above short run neutral estimates would be needed.

And finally, while it is true the more hawkish FOMC members virtually threw in the towel on their traditional Phillips Curve assumptions for a tightening labor market driving inflationary pressures higher, those assumptions are by no means entirely vanquished.

It takes a long time for staff to shift the forecasting process and assumptions even if inflation expectations are now seen as the primary driver to underlying inflation trends; and if the economic expansion is now forecast to be extended, even if growth is slowing, ever tightening labor market conditions and rising wages will still raise enough renewed inflation anxieties for many FOMC members to shy away from flatlining their assumed appropriate rate path just yet.

And it is probably worth noting that flatlining the rate trajectory this soon would create a potentially painful messaging pirouette yet again for the Powell-led FOMC if the data should surprise to the upside in the second half of the year.

An Inflation Overshoot?

Although we don’t really expect much change in the median real growth, unemployment, or core PCE projections, there could still be some interesting movement in the SEP longer run estimates. These adjustments, if they show up in either the median or certainly in the fuller range estimates, would be a clear indication of the movement in the way Fed staff across the system are reworking their assumptions for how the inflation formation process is evolving.

Trend growth, for instance, may see a handful of members doing their optimistic best to mark up their estimates for trend growth to 2% from 1.9% in December, if not in the median, certainly in the fuller ranges.

But more tellingly, we suspect the longer run neutral estimate for unemployment, or NAIRU, may see the biggest change, with the median dropping all the way down to perhaps 4.2% from December’s 4.4%, which in September had already been lowered to 4.5% from the 4.6% level assumed for some time before that.

Perhaps the single most interesting median to watch for on Wednesday will be the core PCE projections: We still assume this year will show an unchanged 2% core PCE, but we will be watching for whether the “patient pause” in rates for much of this year will mean enough of a “high pressure” economy extending into next year that it allows the Fed to perhaps generate a modest overshoot of the 2% inflation target in either or both 2020 and 2021.

If so, it would amount to a defiance of sorts to the more somber fears for a persistence in low inflation that seems to be currently prevailing across market expectations and in some pockets of academia and the Fed itself.

It would also be tantamount to something of an inflation “averaging” on the sly, much in the way the 2% inflation target was signaled for years before being formally adopted in 2012 with forecasts that always marked inflation at 2%.

One benefit to penciling an inflation overshoot back into the projections, either in March or June, would be in helping to deflect how a somewhat premature selling of inflation averaging by several FOMC members as the most likely outcome to the Fed’s policy framework review — a year-long process only just now getting underway – may in fact be paradoxically driving down expectations on inflation when the Fed is looking into optimal ways to nudge them and inflation higher.

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