Two themes are foremost on the minds of the Federal Open Market Committee members as they head into their year-end December 16-17 meeting. Well, three really.
*** A solid Committee majority remains confident in a “near 3%” underlying pace in US growth and it is showing up in the more hawkish tone of recent remarks. There are near term downside risks in the lower growth and dis-inflationary price pressures from abroad, and there is some uncertainty over whether a modest uptick in inflation and higher wages will show in the data by summer. But the net gains in the lower oil prices, coupled to a likely boost in higher fiscal spending, are likely to translate into an upside risk to the forecast by the second half of next year. ***
*** Anxious the fixed income markets are too “complacent” in underpricing a rate hike, the Fed’s messaging in the coming months will be on a lift-off that is “nearing” and especially on a tightening pace that is likely to be very gradual, at least in its initial phase, with each rate decision on a meeting to meeting basis to assess the transmission across the yield curve and into the real economy. In stressing a pace that is likely to be neither “measured” as it was in 2004 nor a shock or as steep as it was in 1994, the Fed hopes to dampen at least some of the market volatility in response to a first rate hike. ***
*** There seems to be no firm consensus yet on the forward guidance in the December statement, in particular, whether to tweak, delete, or keep the “considerable time” language. Its fate will ultimately be determined by whether the Committee is confident enough in its growth projections and for a slowly rising inflation to signal a more definitive hawkish turn, which on balance, may still be a bit premature. On that score, Friday’s Nonfarm Payroll may have an out-sized impact in tipping the balance either way, in particular, if there is even a whiff of a pick-up in wage growth. ***
As we have been writing for some time now (SGH 9/23/14, “Fed: The Dots and the Trajectory”), our sense is that a Committee majority sees the June 2015 meeting as the fulcrum around which the “sooner or later” language rotates, which made its way into the October meeting statement after first being introduced by Chair Yellen over the summer. And so we are still penciling in the June meeting as the most likely start to the first rate increase by the Federal Reserve in a decade, and which will probably take the federal funds target to no more than either side of 1% by the end of the year.
Medium-term Upside Risks to the Forecast
The obvious game changer to the US growth outlook in recent months has been the 40% plus drop in crude oil prices in the last five months that has pushed retail gasoline prices down by a quarter to a national average of $2.74 a gallon from $3.68, which translates into a $75 billion and counting potential boost to consumer spending.
In its broadest terms, as several Fed officials have been stressing, the fall in oil prices is an indisputable boost to growth, but its effect in fact will be coming in stages, with the bulk of its net positive impact only showing up in the data much later, perhaps not until the second half of next year. That closer look into how lower energy prices ripples through the economy is important in how to judge the Fed’s central tendency forecasts for next year.
The immediate impact of the lower oil prices is in fact mildly negative – which may account for the modest downward tweak in growth mentioned in the October Minutes – in that it first delays new investments by the energy and mining sectors, which between them have accounted for perhaps 30% of US business investment spending in recent years. While existing investments will continue, companies will tend to postpone new investment spending plans until they can reassess how long lasting the lower prices are likely to be and how they might alter the marginal return of an intended investment.
Likewise, because the US is producing so much domestic oil compared to previous decades, there is more of an initial offset of the dollar going into the pocket of the consumers being a dollar less for the retail gasoline station and distribution or refining sectors of the economy.
In time, though, the lower gasoline costs (and perhaps lower home heating oil costs) will steadily add to the consumer propensity to spend, while lower energy costs will in turn trigger new investment spending by the non-energy sector. The boost to growth will steadily increase through next year and is expected to be quite significant by the second half of next year.
The same can be said about the likely boost in federal spending this year and next, and what could be an even stronger fiscal tailwind in 2016 (see SGH 11/14/14, “US: Political Headwinds, Fiscal Tailwinds”). Federal outlays in the third quarter this year, for instance, were already some 10% higher than the year before, according to the BEA. Most of it was due to higher defense spending, which more or less is the direction a Republican-controlled Congress is going to take the budget next year.
That likelihood of higher federal spending and its subsequent boost to growth after the years of fiscal drag will be welcomed by Fed officials, but for now it remains an upside risk to the forecast rather than a reality penciled into the projections until the CBO issues a new budget baseline in early 2015.
Nearer-term Downside Risks
Against that backdrop of the Fed’s sensitivity to upside risks to the forecast, the fixed income markets have in contrast been almost exclusively focused on the near term downside risks to US growth in the global downturn and potent dis-inflationary pressures, especially from Europe.
The travails abroad tend to feed into the secular stagnation thesis and the chatter of an extremely low “new normal” in equilibrium interest rates, perhaps coincidentally being embraced by a bond-heavy asset management sector, or a hedge fund community successively burned so far this year on short positions in the bet for higher yields.
And there is a prevalent view, at least going into a year-end where the risk on the trading books has been wound down, that the Fed’s messaging of a looming rate hike will not be believed until it happens, or that the first sign of market turbulence will cause the Fed to step back. Up to now, there has been no cost in staying long, really long, in fixed income and credit products.
What’s more, the wage and inflation trends would seem to reinforce that stance. The most recent third quarter gross domestic income registered a 4.5% growth, but the labor income revisions to the second quarter cut wage and salary growth in half and trimmed real disposable personal income to 3.1% from 4.4%. And that was on top of October’s NFP print with still lackluster average hourly earnings at a 2.2% annualized pace, while broader Employment Cost Index likewise rose by only 2.3% over the prior four quarters.
Worse, the GDP third quarter revisions put core PCE at barely 1.4%, a drop from the 2% registered in the brief uptick in the second quarter, and the lower oil prices and stronger dollar are almost certain to drive inflation a bit lower still in the coming months.
The Fed is hugely sensitive to the renewed persistence in low inflation, and readily acknowledges the risks in the weakness abroad and the further near term downward pressure on most US inflation measures due to the imported disinflation in the stronger dollar and the lower oil prices.
It is likewise fair to say many Fed officials are becoming a little anxious that the drivers to the projected rise in the underlying inflation are not entirely clear, and just how soon those core measures will start showing a consistent upward track is equally uncertain.
Indeed, the most troubling aspect of the renewed persistence in low wages and especially the flat wage growth is that the trends are still a bit hard to understand, and tend to create no small amount of uncomfortable uncertainty in the assumptions being penciled into the forecasting models. That anxiety will only build if there should be a few more similar dips in the real economy surveys of inflation expectations.
With headline unemployment at 5.8% and falling, there should have been at least a little upward wage movement, for instance, and the longer core inflation is trending sideways around a 1.5% level, it will be that much harder for the FOMC to stick to the reassuring forecasts for steadily rising inflation in the medium term.
So if truth be told, the Committee will want to see, needs to see, at least a token uptick in inflation and wage measures by late spring and early summer if the projected growth and job gains continue on track to the central tendency forecasts. At minimum, trying to raise rates with an inflation rate still stuck around the 1.5% level would create not insignificant communications problems for the FOMC.
The Higher Odds to the Upside
All that said, however, the travails abroad are risks rather than realities, and the concerns of a financial crisis spillover or a confidence shock if Europe spirals further south have in fact diminished. As long as the damage to US growth is limited to weaker export growth for a while, the Fed’s forecasters can live with it, bolstered by how much of the US growth is indeed domestically-driven. And who knows, perhaps Europe will get its act together and will by 2016 be adding rather than subtracting to global growth tailwinds.
The same assumptions are driving the Fed’s assessment of the low inflation risks. For now, the FOMC’s policy deliberations over at least the coming months will be premised on the bet the lack of wage growth or higher inflation only reflects a still very flattened Phillip’s Curve in the wake of the Great Recession, but one that will in due course revert to mean.
Perhaps there is in fact still significant slack in the part-time versus full-time labor data, or the longer run level of unemployment is indeed much lower, closer to 5% than previously assumed, and the “pent-up wage deflation” thesis cited by Chair Yellen in her August Jackson Hole speech may still come to the fore.
Or perhaps the lack of the much sought wage growth and inflation is due to a bit of all of the above; but the working assumptions remains that core inflation measures will eventually show signs of life on the back of wages measures slowly rising from their current levels towards the 3% mark through next year and to a much healthier and welcome 4% plus in 2016.
On balance, then, those medium term, higher probability upside risks will dominate over the nearer term, lower probability downside risks in the FOMC policy calculations over the coming months. And more to the point, as we have noted previously (see SGH 10/3/14, “Fed: A “Patient” Reaction Function”), as long as the growth and job creation projections bear out in the first half of next year, low inflation in itself will not be enough to preclude a first rate hike as soon as the June FOMC meeting, with an outlier chance of a caution on those inflation and wage numbers showing up and putting off that first move to September.
Messaging the Markets
And so going into the December meeting, the FOMC may be more attuned to the risks in the market “complacency” rather than distrust or doubt over the forecasts. On this score, two issues dominate the Fed’s thinking, or apprehension might be the better description.
The first is that if the market continues to underprice the probabilities of a first rate hike in “mid-2015” despite the current trends in the data (sans inflation), it could elevate the risk of an excessively violent reaction in re-pricing across the fixed income markets, especially if the market prices in much of the entire assumed rate tightening trajectory off the back of the first rate hike.
The Fed, in effect, is searching for a middle policy path between the “measured” steps of the 2004-2007 rate tightening trajectory, which stoked so much of the excessive leverage in the build up to 2007, and the 1994 rate hike cycle that proved to be such an initial shock with a fairly rapid ascent by the spring of 1995 that sent the markets reeling in a violent tailspin.
Fed officials will therefore continue with recent messaging, most notably by Chair Yellen, Vice-Chair Stan Fischer, and New York Fed President Bill Dudley, stressing the data-contingent path, and that the data, well, looks pretty good, even promising, that the long awaited lift-off in rates after six years at the zero lower bound is looming on the near horizon. They have likewise been forewarning of a likely market volatility that is likely to greet a first rate hike, with the implicit assertion the Fed’s policy path will not be unduly influenced or push back by nasty reactions in either the bond or equity markets, i.e. there is no put, really.
And equally or more importantly, Fed officials are likely in the coming months to put a strong accent on the very gradual path of rate hikes that is likely, a cautious approach to gauge how the market reacts as well as the real economy to a first tightening in financial conditions in a decade. The hope is that by stressing how slow and gradual the ascent may be, the market may be less inclined to aggressively price in an assumed entire rate hike cycle in the first rate hike.
There is already some thought among some Fed officials to convey a probability that the Committee will “pause” in the rate tightening at or around the 1% level for a “lay of the land” assessment of the impact of the rate hikes on the financial and real economies. It is an echo of a case made a few years ago by former Kansas City Fed President Tom Hoenig who argued for moving sooner to get off zero and to then hold rates at a level still under neutral for a while to assess the impact.
The pause probability, however, seems to be fading or has at least lost some of its allure in favor of the messaging that the subsequent rate decisions will be taken on a meeting to meeting basis in appraising both the data and how the market is reacting to the policy moves and, of course, just how responsive the real economy is to even a slight tightening after so many years of low rates.
A Greenspan Conundrum Redux
One last thought to plant in the assumptions over the feedback loop between policy and the market reactions, the Fed may not necessarily see a return of the “Greenspan conundrum” — an unresponsive flattening yield curve — as a bad thing during the initial phase of the rate tightening to come.
There is always a major concern among any central bank over monetary control if it should seem unable to induce the sort of tightening in financial conditions it intends in raising short term interest rates. But on the other hand, this cycle is likely to be like no other and besides, the Fed not only is supremely confident it has the tools to lift short rates, but it also has the option of using its balance sheet as an additional policy lever to influence the longer end, if it comes to that.
But if a primary concern is the risk of an excessively violent market reaction in finally moving off the zero lower bound, a delayed response in a pricing out across the curve may make the market adjustments that much smoother and less risky to the real economy; assuming of course the tightening further out the curve would come in time, it would certainly be more gradual, and could neatly fit with the Fed’s own sense of just how gradual and long the upward trajectory in rates is going to be.