Fed: Nothing to Lose but their Chains

Published on February 24, 2015

“I’m not in favor of chaining the Federal Open Market Committee to any rule whatsoever,” Federal Reserve Chair Janet Yellen said in reply to a question from Senate Banking Committee Chairman Richard Shelby, who asked whether Fed policy should be rules-based.

Her answer could be expected, of course, but it struck us that she could have been talking about the restrictions of the Committee’s own forward policy guidance.

*** By that we mean what we took away above all else from Chair Yellen’s deftly handled appearance on Capitol Hill today was how successful she was in effectively decoupling the tight link (or the chains to complete the metaphor) between the sequence of changes to the forward policy guidance from the actual decision to raise rates. ***

*** The FOMC could, in theory, tweak the guidance as soon as March to introduce an immediate policy flexibility, though April might make more sense to avoid some initial confusion but still keeping June a “live” meeting. But we still think June would be the earliest possible meeting before they will have enough evidence on an upward rise in inflation to make the decision to raise rates. ***

*** Taken together, that to us, corrects some of the slippage we saw towards September as the first rate hike (SGH 1/7/15, “Fed: Two out of Three Ain’t Bad”) and, in turn, brings a first rate hike probability back to more evenly balanced odds between September and an earlier move in June, but perhaps leaving the scale still tipping modestly to September. It will depend on the data, which we suppose, is the point. ***

A Two Track Policy Normalization

When the FOMC does drop the “patience” language, it liberates them from the two meeting definition obviously, but when they do, it does not necessarily lock them into a first rate hike at the next meeting (as it did for instance in 2004), or even the meeting after that, for that matter; it will be truly data-dependent as they have been saying for ages now, only now they seem to actually mean it.

That change could of course come as early as the upcoming March meeting, though it would create an awkward conflict of guidance messaging, i.e., if “patience” means two meetings, its inclusion in the January statement rules out April, but if it is dropped in March, it reopens April, which we seriously doubt the FOMC has any intention of doing.

So either the Committee comes up with a clever tweak in the March statement keeping a modified “patience” in there, or they could simply take their time in the guidance language shuffle, keeping the patience phrasing in the March statement guidance, and use Chair Yellen’s presser to hammer home that a change to some construction of the “meeting to meeting” phrasing could come as soon as the non-presser April meeting statement.

That, in turn, would keep June firmly on the table — or July, or September, which, again, would be the point of a guidance change. Or if the data looks to be going a bit too soft through this spring, the FOMC can always hang back and make the change from “patience” to the “meeting to meeting” guidance in June, and so on.

But the point is Chair Yellen has already teed up expectations that maximum policy flexibility will be given back to the FOMC to react solely to the data when it comes to making that critical decision for a first rate. And we suspect it will be reinforced in speeches and remarks later this week by other Fed officials.

Inflation Looks to Drive Rate Timing

Furthermore, clearing up the sequencing of the guidance is distinct from the actual decision to raise rates. The latter will be based on the data, of course, — again, when is it never the case — but more specifically Chair Yellen to us seemed to put a greater weight than before on the need for the Committee to be “reasonably confident that inflation will move back over the medium term toward our 2 percent objective” before they raise rates for the first time in more than a decade.

Several Fed officials have previously stressed their desire to see clear evidence inflation is adhering to the path seen in the forecast, and Chair Yellen herself alluded to the need for that evidence in her remarks to the press after the December FOMC meeting. But this marks the first time it was made so explicit in either a statement or the formality of a testimony to Congress.

So the question, it seems to us, is how soon will the cheaper oil-driven downward pressures on inflation wash through all the inflation measures — core, headline, trimmed mean, chain-weighted, take your pick — to give a clearer picture of the underlying trend in inflation, and whether it is indeed being tugged upward, however slowly, back towards its 2% medium term inflation target?

The Fed forecasts are built around Phillips Curve assumptions that as the headline unemployment rate pushes through its assumed NAIRU levels, wages as the last leg of the long labor market healing process will slowly, finally, begin to rise more steadily, with an upward push on inflation to follow.

There is, however, some concern within the FOMC — and not to be underestimated — that the inflation dynamic is less understood than any model can promise, and that it may take a long time for the lower energy prices to work their way into the second round effects across the broader economy; or if the low inflation persists for much longer, it could get embedded in falling inflation expectations and become that much harder to reverse (see SGH 2/18/15, “Fed: The Minutes, the Testimony, and into March”).

A rate hike or even a signal of a rate hike from that perspective, could undermine the recovery, snatching defeat from the jaws of victory. Is that risk of a premature hike after six plus years at the Zero Lower bound worth it, unless the FOMC can be sure inflation will behave as the models say it should behave?

Taken together, June could be on the table if the FOMC opts for policy flexibility as soon as prudently possible in either March or April, but the decision to hike rates is more likely than not to need until at least the June meeting.

An Evolution in Guidance

This liberation of the rate decision from the restrictions of the guidance may mark the culmination of the broader debate the FOMC has been engaged in across the last several meetings over its communications policies (see SGH 2/18/15, “Fed: The Minutes, the Testimony, and into March”). The subcommittee on communications led by Vice Chair Stan Fischer has been deeply engaged in assessing potential changes to the quarterly presentation of the Summary of Economic Projections and ways to improve the Fed’s overall communication process, among other topics from what we gather.

But the discussions have invariably revolved around the role and function of the forward policy guidance in a period of policy normalization as opposed to when the Fed was scrambling for new policy tools at the Zero Lower Bound.

Various Committee members have been suggesting for some time now that as a rate hike nears, the need for explicit guidance will diminish, and that the FOMC could or should move towards a vaguer style of guidance as they did before the August 2011 statement that introduced the calendar-specific guidance.

At the time, the FOMC was still groping for the ideal combination of Large Scale Asset Purchases and forward policy guidance to ensure enough monetary accommodation amid a subpar recovery. They finally found the sweet spot with the September and December 2012 embrace of the open ended bond purchases coupled to the Numerical thresholds to ensure rates stayed lower for longer and to deter the market from pricing in higher yields.

But as policy normalization nears, Fed officials have been making the case the need for such an explicit guidance as a policy tool is lessening, and that its purpose may be evolving towards providing a vaguer sense of the reaction function to incoming data rather than a bald time-contingent commitment.

Yellen seems to have put the formal stamp of a testimony before Congress that this shift to a pre-August 2011 guidance will indeed be underway in the language transition from patience in removing monetary accommodation to a “meeting to meeting” watch on the tower.

This was, of course, a moment long in coming, and inevitable, but it may be coming a tad sooner than expected. In any case, the markets will know one way or another as a Committee consensus comes together in the run up to the FOMC March meeting.

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