For all policy debates and decisions since the Federal Reserve resorted to unconventional policy measures more than eight long years ago, Chair Janet Yellen has in recent months managed to steer the Federal Open Market Committee to a remarkably solid consensus on near term rate policy, as well as to make considerable headway on the FOMC’s still emerging balance sheet policy.
The balance sheet, in particular, is certain to be a major subject of discussion in the FOMC’s two-day meeting that starts in an hour or two. But otherwise, this May meeting should be something of a prelude to the heavy lift of pivotal policy decisions looming later this year.
*** Despite recent softness in some data, we believe the Committee rates consensus continues to tip towards a June rate hike and, assuming the data cooperates with an above trend growth, to be followed by at least one more rate move before year-end in an upward climb in rates towards neutral. For tomorrow, there will be no rate move obviously, nor is the statement likely to include any overt rate signaling beyond the descriptive update on the economy and little, if any, changes to the inflation outlook. While probably too early to do so, we do wonder whether the FOMC might be tempted to insert a clause or phrase into the statement affirming the progress to date on balance sheet policy. ***
*** The FOMC has indeed made considerable progress on portfolio normalization, though numerous technical decisions still remain that will probably entail further staff work beyond this week. But the crucial consensus decision is broader, about the principles of whether the balance sheet shrinkage will truly be on a passive “auto-pilot” towards a smaller, minimalist balance sheet or whether the FOMC will affirm its current lean in favor of a larger balance sheet and perhaps in keeping its options open on the balance sheet down the road. Indeed, we suspect that debate will be defining a new dynamic between “institutional hawks” and “activist doves” in the next stage of monetary policy. ***
*** On the question of timing and sequencing, a distinction should be made between the Fed’s preparations to be positioned with the updated Exit Principles and Plans, which could come as soon as the summer or, we suspect, the September meeting, and the actual end to reinvestments, which will depend on economic conditions. With a long runway of communications along the way to ensure minimal market disruption both domestically and abroad, our sense is that it will take until September for Chair Yellen to forge a solid consensus on the balance sheet policy and, despite a degree of urgency creeping into the FOMC discussions — certainly in the external speculation — for the tapered roll-off of maturing assets to begin in the final months of the year. ***
June and (at least) One More
One of the more impressive aspects of the FOMC’s March rate hike was how quickly Chair Yellen was able to pull together a consensus for the rate move and the almost unusual consistency in the Committee messaging in the run-up to the meeting (see SGH 2/22/17, “Fed: Hello March”).
Not only did the FOMC raise rates a third time, and only three months since the second rate hike in December, but the FOMC majority since then appears to be just as on board with the base case for two more rate hikes this year, maybe even a third for four in total, in one form or another.
As we wrote previously (see SGH 4/7/17, “Fed: Rates, Neutral, and the Balance Sheet”), the aligned messaging and rate move reflects an important pivot in the policy stance now that the economy is at or near both the Fed’s mandates for maximum employment and 2% inflation. The data against that backdrop will be assessed with a burden of proof on those Committee members to make a case against lifting rates again, in this case, at the upcoming June meeting.
A rate hike in June does indeed still appear to be a base case assumption, despite some softening in recent GDP and other data as well as the surprise dip in the most recent inflation prints.
Key to the Fed’s calm about the stubbornly persistent low inflation is an underlying assumption that inflation will tend to be extremely inertial, trending sideways, supremely anchored by stable inflation expectations, never sliding too far south despite the abundant slack in the wake of the crisis, nor likely now to rise all that much even when slack is long gone but with businesses still struggling to find sustained pricing power.
As long as growth and more specifically as long as the labor market continues to tighten — job growth above the 100k a month mark, a stable or even slightly rising participation rate, and some decent wage growth for good measure — the Fed’s most basic assumption is simply that inflation will be rising, not falling, in the period ahead.
For a FOMC majority, in light of the benefit of the doubt they will be giving to indications of still soft price pressures, they will be reluctant to back away from the current hawkish lean unless the jobs data unmistakably undercuts their confidence in the economy’s upward trajectory. And that, in turn, puts a relatively high importance on the next two Non-Farm Payrolls before the June meeting, starting with this Friday’s number.
The last NFP was not nearly as weak as many took it, and downside surprises are not expected in this Friday’s print. But if the breakdown should display any hard to ignore downside surprises — not so much in the jobs number itself, as it would have to show an outright plunge to get attention, but more in a flat lining or falling participation rate, mediocre average hourly earnings or weekly hours worked — then there could be a modest rethink across the Fed starting to set in, and the weakness in the most recent inflation measures would, in turn, take on a new meaning.
In that situation, the more dovishly-inclined Committee members could and would make a much stronger case for caution in a rate move in June. At minimum, there would be a more balanced tone to the Fed messaging on the near outlook that would probably pull the pricing probabilities for June back below 50%. But for now, that is not the FOMC’s base case scenario.
Advancing the Balance Sheet Policy
It is worth noting that the same track in economic activity will likewise be defining the timing to the eventual start to a planned portfolio normalization before year-end, if not months before.
The framework for when the balance sheet shrinkage can get underway has been defined by a general desire for having the rates policy normalization already “well underway.” That is going to be more or less a qualitative judgment by the FOMC, but it is largely understood as a fed funds rate at or near the 1.50% mark, or at least two more rate hikes from now.
The preference among many Committee members is in fact three more rate hikes to get the fed funds target range up to 1.50-1.75%, which they would argue provides sufficient easing cushion if the economy should turn south or if the balance sheet reduction should widen the term premium and spreads so much it in effect drives the neutral rate lower.
Perhaps more to the point, it is the pace of rate hikes as much as it is the level of the policy rate that is defining whether rate normalization is well underway. And by that measure, a June rate hike, or three moves in three quarters, much less a fourth in September, is for a Committee majority already meeting the criteria to consider the next step of policy normalization through right-sizing the balance sheet.
The FOMC has indeed made considerable progress on its principles and plans for portfolio normalization, with a Committee consensus so far that rates will remain the primary policy tool, the start of the balance sheet roll-off will be well-telegraphed to minimize market dislocation, it will be gradual and probably passive to keep it “in the background,” and that it will be tapered to smooth the pace of what will be both treasuries and the MBS holdings no longer being reinvested, with an unlikely sale of assets during its early phases. A Committee majority also clearly wants to end reinvestments before year-end.
There remain, however, numerous technical decisions to be made, among them how much to roll off each month and whether set in a fixed amount or as a proportion of total assets each month or quarter, and whether the maturities of the assets reinvested will be shortened or continue to be set to Treasury’s auction schedule. Wrapping up much of the more technical details seems likely as soon as this week and with further staff work, by the June or July meetings.
Seeking Broad Consensus on Exit Principles
But our sense is that more likely than not it may nevertheless take through the summer months for Chair Yellen to bring together a solid Committee consensus on the broader principles of the portfolio normalization as well as the more technical plans. That, to us, points to a September unveiling of the portfolio normalization principles and plans, with the first roll-off of a portion of the maturing treasuries and MBS coming in the fourth quarter this year.
A clear majority of the current Committee favors an eventual right-sized balance sheet that will be larger than in the past of at least $2.5 trillion and probably larger, in order to include a significantly higher level of excess reserves to cushion the financial system with liquidity and a source of safe assets. As indicated in the November meeting Minutes, the movement within the Fed is also towards embracing the current “floor system” with abundant reserves as its operating framework to succeed the older scarce reserves and a minimalist balance sheet.
Many Committee members also seek to reserve the option of using the balance sheet as a policy tool “down the road,” adjusting the pace of the balance sheet reduction, for instance, or even reversing it with a new round of QE if the economy falters and rates are pushed back to the effective lower bound. Still others wonder whether the balance sheet in time could be used to fine tune financial stability objectives, an idea floated by the still influential former Fed Governor Jeremy Stein.
But even if outnumbered, those whom we would describe as “institutional hawks” are likely to be that much more passionate in their arguments for a return to a more minimalist balance sheet and above all, to blunt any further movement towards the balance sheet as a policy tool.
What’s more, always lurking in the background is the keen awareness of the bad optics and politics of Capitol Hill’s critical eye on the issue of the Fed’s remittances to Treasury that are fated to be shrinking, and the interest on reserve payments going to the banks, and foreign banks, to boot.
Why linger any longer than absolutely necessary in the uncharted territory of a outsized balance sheet and abundant reserves? There is safety in the familiar.
It has been a hallmark of Yellen’s style of leadership to move cautiously and methodically to shore up a solid Committee consensus without dissents, and that is likely to hold true on such a critical policy step as the last leg of a decade-long normalization of the Fed’s monetary policy.
In that sense, the long run up to the December 2015 rates-lift off is likely to be the template for a similar carefully nurtured consensus on the balance sheet before a single bond ever rolls off.
That will especially be the case when she and her colleagues are fully aware there is likely to be a new Chair by the first quarter of next year, with three new Trump Administration-appointed Governors coming to the Board before year-end, and with perhaps the entire Board changing by the end of next year.
To be charitable, the current FOMC will want to move far enough along on the revised Exit strategy to minimize any volatility in a new and untested leadership left to execute a balance sheet strategy from scratch. It is also just not within the collegial culture of the Fed for one FOMC to thwart or seek to limit the policy options of a future FOMC.
But if the economy is far enough along to warrant the start to a balance sheet policy built around a solid consensus for a gradual, passive, and predictable path to shrinking the balance sheet before the Committee turnover, then so much the better.
But again, at the end of the day, it will be the pace of the economy not the politics that will drive the portfolio normalization time line.