There are four main points to our expectations for today’s Minutes release of the June Federal Open Market Committee meeting and, most interestingly, the FOMC’s efforts to transition from its near-term crisis management efforts to longer run monetary policy:
*** Despite the relatively high expectations the FOMC may soon adopt some form of yield curve control, we have no sense of any movement towards a Committee consensus that would put a decision on yield curve caps on the table at the July meeting or even by September. The Minutes later today are instead likely to show how preliminary these discussions are, and while YCC may become part of the monetary policy toolkit at some point, we don’t think a clear Committee majority will turn to YCC unless or until there are clearer signs of sustained economic recovery, which is likely to push their consideration into next year. ***
*** We instead think the Committee is leaning more favorably towards a two-tracked playbook when constrained at the zero lower bound, which may be reflected in the Minutes: an aggressive forward policy guidance that rates will be held lower for longer, until outcome-based thresholds are achieved with inflation back to its 2% target and unemployment to its estimated longer run levels, and reinforced with open-ended, large scale asset purchases weighted to longer term treasuries. The Committee, for now, seems more comfortable with this “evolutionary” transition back to a monetary policy stance, one that will be easier to message, and offering greater control over the balance sheet. ***
*** The Minutes may also provide an indication of whether the transition to monetary policy will be sequenced in two steps, which we think likely. The first would be a general consensus statement of the new monetary policy framework, the FOMC’s guiding “principles” built around the prior work to revise the annual “Statement of Longer-run Monetary Policy and Strategy.” The framework will lay out in broad terms the Committee’s objectives when facing an extended period of a low equilibrium interest rate, including a commitment to incorporate past performance into “make-up” strategies to ensure an average 2% inflation target over a course of the business cycle. It will be a remarkably dovish “constitutional” document. ***
*** The new framework could also include an additional document or addendum with the specifics of the changes going forward to the guidance language, the thresholds, and the scale and targeted maturities of the large scale asset purchases that would then become a key policy plank in the formal meeting statements to provide the accommodation to support a sustained recovery. We suspect this policy playbook, however, will come subsequent to the release of the framework, culminating a communications campaign to cement expectations and maximize policy credibility. For now, September remains the base case for its release, though it could still come later in the year. ***
The Early Stage of the YCC Debate
While we are skeptical the FOMC will turn to some form of yield curve caps any time soon, we would not rule on the introduction of YCC further down the road, and it is likely to be apparent from the Minutes that YCC has its attractions for more than a handful of proponents on the Committee.
For one, it could be a powerful “commitment mechanism” to bolster the credibility of what is likely to be a very aggressive forward guidance that may stretch out for years. And even if there is still an initial majority of the Committee generally antithetical about the potential loss of control of the balance sheet that is implicit in a commitment to a price at some point or along the entire curve, if well executed, it may leave the markets to do the heavy lifting and not require the purchase of many treasuries by the Fed at all.
Staff work is already well underway in assessing new estimates of the equilibrium yield curve as the basis for gauging where the optimal rate would be, whether at the three year, five year or ten year, for instance; staff reviews were provided at the June meeting of the recent experiences with YCC by the Reserve Bank of Australia and the Bank of Japan. The US capping rates across the length of the yield curve to help the financing of the Second World War also drew staff work, though the emphasis there was likely to have been on the difficulties in its exit in the turbulent run up to the 1951 Accord with Treasury.
The Minutes may also provide a sense of the contrasting views on optimal timing if YCC were introduced. In the near term, for instance, many Committee participants will argue there is hardly a need to cap yields when no one doubts how long rates will remain low, which means the cap would provide little, if any, accommodation. A turn to QE, on the other hand, is more familiar, with more research behind it, and it offers far greater policy flexibility, no small consideration for most of the Committee, including we suspect, the Chairman. The Committee thinking is in some sense skewed towards QE, in that it would be easier and faster to get to a consensus.
The counter argument that will invariably show up in the Minutes is that the YCC would need to be introduced early in the transition to monetary policy to maximize its credibility to limit the probabilities for a scaled market testing of the cap; an early and convincing introduction of the YCC paradoxically prevents the very loss of balance sheet control its detractors fear the most.
And while it may seem a cap somewhere on the yield curve may not be needed now, that assumption could soon be sorely tested if federal borrowing continues to skyrocket and the desired investors with firm hands don’t show up without the higher yields of a steepened curve. And as markets are almost by definition too quick in its pricing, the Fed may find itself scrambling to ensure an accommodative stance to prevent a premature tightening in financial conditions, and chasing its own tail to defend the cap from a position of weakness.
We suspect, however, considering the conservative nature of the FOMC, there will remain a reluctance to embrace YCC in the near term. The FOMC will we think still be weighing its options over the course of the next few meetings on whether YCC could still be introduced as a supplement to the twin tracked forward guidance and QE in a kind of “belts and suspenders” approach further down the road.
A Still Elusive Consensus
And finally, one complicating wrinkle to the unveiling of either the new policy framework or the more detailed policy playbook to guide policy expectations at the zero lower bound is that there are several still unresolved points that need to be overcome to achieve a desired consensus with both documents, especially the general framework.
On the expected outcomes-based thresholds setting the parameters to the lower for longer rates guidance, for instance, the Committee voters must still decide on the inflation target, whether to be more aggressive in citing a willingness to overshoot to as much as 2.5% or where to pin the latest estimates of the longer run unemployment level.
And while there was apparently a strong consensus at the FOMC’s January meeting on the tweaks to the inflation language in the longer run statement — more or less to add the phrasing about an “average” 2% target “over the life of a business cycle” — some of the more hawkish-leaning Committee participants were also pressing to harden up the language currently referring to the balance of risks “including to financial stability” to provide, in effect, a financial stability “escape clause” to the overall highly dovish thrust of the commitment to tolerate if not engineer an inflation overshoot through a potentially extended period of low rates.
Judging by Chairman Jerome Powell’s curt dismissal of near term financial stability risks at the June meeting presser — “We’re tightly focused on our real economy goals and we’re not focused on moving asset prices in a particular direction at all” — we are assuming that argument has yet to make much headway. For now, it seems apparent that while Chairman Powell may still hold not insignificant concerns over financial stability risks, his more pressing policy priority is the need to aggressively use monetary policy to underpin a sustained drive to counter this prolonged period of low inflation and to return to the maximum employment the Fed had achieved by the end of last year.
Indeed, if former Chair Janet Yellen was strongly sympathetic on the immense social pay-off in a high pressure economy that tightens the labor market, on that front, Chairman Powell has evolved in his views towards an even more aggressive version of Yellen’s arguments: in the window offered by the persistence of low inflation, bringing the labor market back to maximum employment and broadening the base of those who will benefit from steady work and higher wages will be the driving policy objective during his term as Chair, and it will be reflected in the eventual monetary policy framework and playbook to be adopted.