No one, including Federal Reserve officials, would want to go through the wild ride in the markets of yesterday and the last two weeks. Today is likely to mark yet more volatility, but they will be immensely pleased, if not relieved, if there is an extended calming effect of the Bloomberg story yesterday afternoon noting Chair Janet Yellen’s still upbeat assessment on the US outlook last weekend on the sidelines of the International Monetary Fund/World Bank meetings.
Most Fed officials are probably not entirely shocked by the sharp turn of events yesterday, though the depth of the plunge in bond yields was positively breathtaking. But Fed officials simply do not believe the market action reflects their near term economic outlook, even when factoring in some mounting global risks to that outlook. Things are just not as bad as they may feel or look.
*** The market shocks and volatility spikes would have to extend further and translate into a significant downside shock to confidence and consumption in the real economy and into the Fed’s forecasting models before the Fed will weigh veering from their base case to end bond purchases this month or to back away from an anticipated first rate hike next year that is, after all, still expected to proceed at a very gradual pace. And for now, our sense is that the Fed views that as unlikely, a risk to be sure, but hardly a high probability reality. ***
*** Looming high on the Fed’s “must do” list is a likely reassessment of its communications policies. FOMC members have adhered closely to the “data-dependent” messaging, but their arguments aired in public over the most likely lift-off in rates, for instance, looks to have only added to the market confusion over the Fed’s reaction function. That was especially the case in the wake of fragile market conditions in the wake of the gloomy all-is-lost mood of the IMF/WB meetings. ***
Yellen’s G30 Remarks
It was in brief remarks last weekend before the G30 — a private rather than public policy organization formed in 1978 — that Federal Reserve Chair Janet Yellen spoke about the US outlook. Yellen said the Fed is still expecting a near 3% growth track over the next several quarters, a headline unemployment rate that looks likely to steadily push through the current assumptions of its longer run levels, and for inflation, while uncomfortably low at present, to slowly rise on the strength of the steady recovery back towards 2% mandate-consistent levels.
In other words, the Fed Chair repeated almost verbatim how she described the FOMC consensus projections at its September meeting. The difference was that she repeated the relatively optimistic outlook on the US recovery amid the deepening gloom hanging over the International Monetary Fund/World Bank meeting, which was more or less stoked by the mess in Europe.
She also noted the FOMC’s 2.9% median projected fed funds rate in its September Summary of Economic Projections was well below the Fed’s projected 3.75% longer run neutral interest rate, and that may have been the more important takeaway from her talk: maybe the neutral rate will be adjusted lower and eventually a little higher as the forecast evolves, or for that matter the fed funds rate may never get to 2.9% or rise still higher, but the real point she wanted to leave with her audience was that the policy rate is expected to still be under neutral even though headline unemployment and inflation are expected to be at their mandate-consistent levels.
The Fed’s reaction function to the incoming data from here, in other words, will be one of abundant patience, and a near term willingness to probe the lower layers of NAIRU at the risk of mild inflationary pressures down the road.
It is probably worth a reminder here that Chair Yellen is certainly dovish in her outlook on policy, although she is not nearly as dovish as the market sometimes assumes her to be; there is a significant difference between being ideologically dovish as the New Yorker magazine may want to portray, and being tactically dovish. Yellen is just as keen as any hawk on the Committee to get off the zero lower bound and is ready to raise rates once the recovery is looking self-sustaining.
So while the Chair and the FOMC will be watching closely for any lasting spillover effects of the current market dislocations, for now the far more likely stance is going to be twofold:
First, she and the other Committee members are very likely to get back on the same messaging page over the next few days in attesting to confidence in the US recovery weathering the current storms, and; second, the timing and pace of the eventual rate tightening will be driven by the cost/benefit assessment that the cost to reverse a higher inflation persisting well above a symmetric 2% inflation target is far less of a price to pay than a persistence in low inflation that leaves the economy dangerously vulnerable to downside shocks, especially when the policy rate is still at or barely above the zero lower bound.
The Dollar and Offsets
Vice Chair Stan Fischer also echoed the September meeting Minutes in his speech or remarks to the press during the International Monetary Fund/World Bank meetings.
Yes, the Fed is monitoring the notable appreciation of the dollar for its impact on the US outlook. But if anything, Fischer noted, the recent rise in the dollar is not nearly as surprising or unexpected as the previous persistence in the strength of the Euro, and so considering the contrasting paths of the two economies, the currency movements seem entirely natural, and perhaps already incorporated into the Fed’s forecasts.
So yes if the global disinflation and slowing growth changed the outlook in the US, it could mean the Fed may remove accommodation even more slowly. But that remains, for now, a big “if” and it still begs the questions of how much more slowly. It probably says something more about how gradual the tightening trajectory is already expected to be, and not necessarily the lift off.
What’s more, other Fed officials have also noted the negative effects of the stronger dollar or even a hefty correction in the stock market are likely to be more than offset by the stimulative effects of lower oil prices and the bond yields that continue to fall. All else being equal — always a dangerous construction of logic to be sure — the added stimulus of oil and bond yields, if broader markets were to stabilize at around these levels, could even in theory translate into the next round of those perplexing blue dot rate plots being marked up, not down.
And finally, the market pricing for inflation expectations has certainly plunged, but how much of that is temporary and driven by a massive wash-out and largely technical factors in the bond market trading rather than an important predictive signal is still unclear. The Fed puts more weight on the less volatile real economy measures of inflation expectations, and a recent Federal Reserve Bank of New York report underscores, consumer and business remain relatively solid and have barely moved.
Still a Considerable Debate
One last point to note is the lingering debate over what to do with the “considerable time” language in the October meeting statement.
We were admittedly a bit surprised how little consensus there was on what to do with forward guidance and the considerable time language at the September meeting, as was apparent in the lack of any clear directional tone one way or another in the Minutes. Our sense at least until yesterday was that on balance the strong lean inside the Committee was still to use an anticipated end to the bond purchases at the next meeting as the most natural moment to move on to something new.
But the market dislocations this week will obviously shape the entire arc of the October meeting discussions and the statement, so it may be a bit premature to weigh the wording of the guidance until at least some of the market dust settles. Its fate will thus depend more than anything else on any changes to the staff forecasts being prepared for the October meeting. And as a practical matter, the markets would have to free fall in the next week or so to garner enough impact on the underlying real economy to alter the forecasting models being prepared for the October meeting two weeks from now.
And the FOMC, come the October meeting will want whatever is done to fit into a framework that will serve the evolution of the guidance through next year, when one assumes, a rate hike looms. Whatever is put into the statement in October should ideally not need to be taken back out in December or even the first few meetings of 2015.
Indeed, considering all that is in play in the two weeks before the October meeting and the lingering lack of a consensus on what to do with the guidance language, we would not be surprised if Chair Yellen calls for another pre-meeting Committee conference call to get a bit closer to a consensus on the guidance changes to avoid the risk of punting simply out of indecision, as though the FOMC had taken over by Europeans.