Probably the most interesting thing about the Minutes to the April Federal Open Market Committee meeting being released next week will be what they reveal about the curious joint session of the Board of Governors and the FOMC that opened the two day meeting.
We are pretty certain the joint meeting was driven by the need to discuss the new facilities, such as the Term Deposit Facility, that fall under the legal jurisdiction of the Board rather than the FOMC (SGH 4/30/14, “Fed: Deepening the Consensus”). And it does at least suggest the FOMC is finally beginning its long awaited revamp to its June 2011 “Exit Principles.”
But equally or even more so in light of the recent market pricing action, the Minutes will also be scrutinized for further clues into the FOMC’s thinking behind its March statement that rates are likely to be “below normal” when the recovery is at mandate-consistent levels of employment and inflation.
That is likely to mean a bifurcated takeaway of sorts for the markets, the former taken as hawkish, the latter markedly dovish. But either way, what it may really mean is that the Fed is at risk of losing control over its messaging at a critical moment in its carefully crafted narrative of recovery and the Exit from the zero lower bound of the last five-plus years.
*** We are not sure the FOMC has really come to any consensus on why or how lasting an equilibrium interest rate below its previously assumed levels of around 4% will be. There is a gathering momentum to a minority view within the FOMC that a declining trend growth will likewise be lowering the equilibrium interest rate, and that persistent low inflation could keep policy falling back against the zero lower bound. But it is equally clear the market is taking the below neutral theme too far, and Fed officials are likely to push back against the chatter of a 2% new neutral. ***
*** And on the Exit, agreement seems to be firming that assets shouldn’t be sold off for some time, that re-investments are likely to be maintained into the Exit rather than marking its start, and that the new overnight reverse repo facility is near certain to be the primary policy tool during the initial tightening phase. The FOMC, however, is still some way off from an overall consensus on the broad Exit framework, the least of which is what role the fed funds rate will play and indeed when and how exactly rates will be tightened. That, we think, will take until at least the September meeting to come together, but market speculation on the Exit details may force more detail to emerge by the time of the June FOMC meeting. ***
Below Normal, Way Below
The dramatic rally in fixed income that has brought the ten year to barely 2.5% in the last week or so has not gone unnoticed by Fed officials.
The Fed has been asking among its market contacts for its surveys why yields have been falling so? Is it because the weight of the pension funds buying the long bond is so large it is pulling down yield levels all along the longer end of the curve? Or is it doubts over the durability and strength of the recovery, or perhaps the skepticism over a falling trend level of potential growth, and the Fed’s ability to ever get to a neutral rate, wherever it may lie?
The fixed income markets have in fact been pricing 2015 and 2016 fed funds well below the FOMC’s own rate projections in its quarterly year end fed funds “dot plot,” and there has been a slew of recent Street research and conferences that have all been speculating on the terminal versus neutral level for rates, pushing the neutral rate down as low as 2% instead of the 3.5%-4% currently prevailing within the Fed.
And for that matter, there is no small amount of thinking still deeply imprinted in market expectations that, well, the Fed may just never be able to raise rates at all, or not until 2016 at best.
It is as though the market has wholly taken to heart the Fed’s “below normal” messaging, only as it often does, it has taken it to an extreme, gathering into a self-fulfilling momentum of a conflated terminal/neutral rate that is not just below normal, but way below the traditional assumption of a 4% neutral rate.
What might the market reaction be to the June SEP dot plot if, in light of the improving labor market and at least some pick-up in inflation, the 2016 dots are further nudged up a bit? Or how will a market in its current state of mind react to the unveiling in September of the projected fed funds dots for 2017, the third year of what would be a rate tightening cycle into the seventh year of the current expansion? And what would be the intensity of any snap-back if those prevailing views are forced to correct?
The Fed had been feeling fairly satisfied that its lower for longer and slower for longer rate trajectory was finally getting across, only now the complacency and lack of volatility feels like the messaging is being taken too far, and that yield compression and rate expectations are simply getting carried away. In effect, the Fed’s core guidance — that the trajectory of the rate tightening will be gradual and that the equilibrium interest rate is a bit “below normal” in the aftermath of the dislocations of the financial crisis — is unraveling.
At least some of this potential unraveling is of the Fed’s own doing. For instance, as much as we may like the Summary of Economic Projections and the rate dot plots — they really do provide a high value glimpse into the assumptions going into the decisions on the tweaks to the forward policy guidance of the formal, voted statement — confusion still seems to run through much of the market over how to interpret rates barely above 2%, with both employment and inflation back to longer run, mandate-consistent levels. Is the Fed saying that rates barely above 2% are about as far as this rate tightening cycle is going to go?
All else being equal — always a loaded phrase to be sure — the Fed has already been nudging its longer run neutral rate lower, from the 4% or higher levels in the first dot plot in January 2012 to five dots now falling below 4% to as low as 3.5% and more likely to go lower as well in the June dot plot (see SGH 3/12/14, “Fed: Equilibrium and the Next Phase of Guidance”).
There has likewise been a parallel downgrade in the longer run growth assumptions of the central tendency forecasts from as high as 2.5 to 2.8% in late 2011 to the 2.2% to 2.3% estimates in the March SEPs. We don’t even want to look at what the Fed thought trend growth potential was in the halcyon days of the late 1990s.
But the point for the Fed is that these ominous developments are reversible and indeed, underpin the modeling and intellectual arguments for an aggressively accommodative monetary policy to prevent this “secular stagnation” from permanently scarring the economic landscape.
Time and the data will tell, but at least in the coming days and weeks, we suspect the Fed will be quite keen to prevent the gloomy assessments from driving yield levels too far south of the Fed’s own growth narrative and projected policy path.
Revisiting the Exit Sequencing
Former Fed Chairman Ben Bernanke promised in one of his press conferences last year, June we think it was, that the Fed’s revisions to its “Exit Principles” would be unveiled “at the appropriate time.” We do think the Exit discussions did indeed finally get underway in April, but we would not get too worked up about it just yet.
Since the Exit Principles were first laid out in June 2011, another few trillions of dollars has been added to the balance sheet, the duration has become longer, new more widely reaching tools made available, and a new layer of forward policy guidance taken into account. It is early days on that complicated, “details will kill you” kind of process, and the Fed would for now like to keep the message on the lower for longer and slower for longer trajectory of the rates guidance to the extent they can.
So we think the FOMC’s sense of the “appropriate time” is more likely than not to come by the time of the September FOMC meeting as the tapering of the open ended regime draws near. But a couple of points of agreement are already coming into view.
Various Fed officials have, for instance, made it clear that the central bank intends to refrain from selling any of its assets and from its MBS portfolio in particular, during “the early stages of the normalization process” as New York Fed President Bill Dudley put it in a speech last year. The FOMC seems likewise to have agreed on the new overnight reverse repo facility is the likely workhorse policy tool for those early stages to the tightening of short term rates.
Our sense is that the FOMC is also moving towards a consensus that the intended end to the reinvestment policy as the opening step to the Exit will be shelved, with no rolling off of the assets to come at least until and probably after the first rate hike. And finally, the FOMC seems to be edging towards a view that the Exit won’t be dragged out as envisioned in the June 2011 sequencing, but that it would probably be better to compress the steps into a shorter time frame or in a more rapid sequencing once underway.
Fed officials are much more confident these days in their ability to manage the return to normalized rates with an out-sized balance sheet compared to when they first laid out the Exit Principles. But beyond those individual pieces of the Exit puzzle, there is still admittedly little consensus on the broad framework to the Exit, centering around whether the fed funds rate will or should retain its status as the primary policy rate or whether its crown should be handed on to the more broadly accessible overnight repo facility.
In any case, the FOMC may be able to punt on the fed funds question for a while, still officially targeting the fed funds rate, perhaps still in a range in the early phase of the Exit, and using the Overnight Reverse Repurchase facility and the Interest on Reserves rates as the primary policy tool. But before then, the Desk still needs to run through many more scaled up test runs of the new O/N RRP facility as well as the older term reserve repo facility and, as announced last Friday, the Term Deposit Facility. The latter two, alongside paying interest on reserves, may be nudged to the rear to play a more secondary role to the new O/N RRP in neutralizing the roughly $2.7 trillion in excess reserves on to the bank balance sheets to fund the Fed’s three asset purchase programs.
Using the trial runs of the various facilities to garner greater insights into the trading dynamics and arbitrage across the short rates markets before ever tightening rates presents is probably the trickiest part of the Exit and how to message the approach. At some point, the O/N RRP rate will need to be lifted above the effective fed funds rate that has been trading in a range on either side of around 7 basis points. But can the Fed sell that to the market as a policy neutral “technical” tightening as opposed to a formal policy tightening, which is assumed to be the lifting of rates above the 25 bp top end of the current fed funds target range?
And for that matter, once it gets to hiking rates, does the Fed necessarily need to move in 25 bp moves as it did pre-crisis or would it make sense to move in smaller increments? And if not, how exactly is the FOMC going to message its quarter point rate hikes across its eight meetings a year if it indeed sticks to roughly a 100 bp worth of rate increases annually as indicated in the SEP dot plots?
The Fed, we think, will be extremely reluctant to chance any misreading of these short rate movements as a tightening until they have further clarity on the recovery having clearly reached “escape velocity” and able to withstand any potential tightening in rates, inadvertent or otherwise.
And the difficulty, some say impossibility, of distinguishing the signaling effects from technical adjustments, in turn, points to a delay in any trial run of the overnight repo rate above the effective fed funds rate until deeper into this year if not early next.