The most immediate reactions to reading through last week’s release of the Federal Open Market Committee’s October meeting Minutes was thank goodness their December 17-18 meeting is still three weeks away.
For if anything else, the remarkable Policy Planning section of the Minutes indicated a committee that was still surprisingly at a brainstorming stage — all over the map if one were less charitable — on the key policy decisions looming on the near horizon.
Nevertheless, since then a consensus does seem to be slowly taking shape on some aspects of near term policy, particularly on forward guidance and communications — with or without a first taper. For now, heading into the Thanksgiving break, three points can be made:
*** First, the FOMC seems unlikely to change either of the Numerical Thresholds at the December meeting. Instead, it is leaning towards reworking the communique to clarify its likely reaction function after the headline unemployment rate crosses the 6.5% threshold: affirming the lower for longer rate path and perhaps noting the lagged neutral funds rate that warrants it, the intention to hold assets on the balance sheet, and pointing to the wider array of labor market indicators beyond the threshold. The Summary of Economic Projections “dots” for a first rate hike and year-end rate levels are also likely to testify to the lower for longer rate path and an optimal trajectory of a very gradual rate tightening. ***
*** Second, our sense is that a majority of the FOMC, particularly the Board, still seems reluctant to begin tapering the bond purchases at the December meeting. That could change for purely tactical reasons, namely, if the FOMC concludes they can do so without disruption to illiquid year-end markets. But their predisposition is for now to wait for more insurance in the data that the recovery is closer to the “escape velocity” of a self-sustaining growth. To that end, the November Nonfarm Payroll number is likely to play an unusually out-sized role for a single data point. ***
*** Third, almost as an aside, there is almost no chance of any near term cut in the IOER, despite the speculation in some quarters to the contrary in the wake of Yellen’s reference to it in her Senate testimony and its mention in the Minutes. A cut in the IOER is a possibility once the new fixed allotment overnight repo facility is fully up and running and only if the recovery stalls or is turning south, but not as some sort of offset to a first taper. ***
Crossing the Thresholds
The FOMC has been debating a potential adjustment in its unemployment and inflation thresholds almost ever since they were agreed to last December. As it became increasingly obvious that the headline unemployment rate was not faithfully capturing the state of the labor markets, the debate picked up in tempo in June, again in September, and at length in October when the FOMC weighed its many paths to reinforcing its intention to keep rates lower for a hell of a lot longer than under any more traditional Taylor Rule assumptions.
The reasons for and against a ratchet down in the unemployment threshold, whether to 6% — the most likely compromise level if that ended up the road taken — or an even more powerful 5.5% level according to one of the Fed academic papers presented a few weeks ago, have been endlessly cited in the public remarks by various Fed officials.
Easily the most potent case against tinkering with the thresholds, and the one we expect will determine the decision in December, is the loss of credibility in a threshold that once changed, can be changed again. Such a change would, a majority of FOMC members believe, only point to the subjective judgment that ultimately lies behind the threshold; discretion without any pretense of rules, however temporary.
And a strong signal of which way the FOMC is most likely to gravitate by the time of the December meeting came in Chairman Bernanke’s carefully written speech a week ago tonight.
Aware the October meeting Minutes would be released the next day, Bernanke made repeated references to “crossing the threshold” with no case being made on the merits of adjusting down the unemployment threshold. It is as much about what he did not say, in other words, that points to where both he and Vice Chair Janet Yellen are likely to press the consensus at the December meeting.
The headline rate, like the North Star, has been useful in guiding policy and the markets up to a point, but as the journey nears the crossing of that 6.5% threshold, policy decisions will be better served by a more detailed, wider array of labor market indicators — essentially Yellen’s earlier “dashboard of labor market indicators like the participation rate or rates of hires and fires — on when to finally raise rates.
What’s more, while Fed hawks and doves alike have stressed the threshold is not a trigger, most of the FOMC is leaning towards a more formal reaffirmation of that message in the statement of the lower for longer rates path and on holding assets on the balance sheet as two powerful ways to reinforce the rates guidance.
The first rate hike and year-end fed funds rate projections can also play a powerful role in adding to the framing of the policy path beyond the threshold. The “dots guidance” is a bit more unwieldy as a tool for guidance since the dots are set going into the meeting, with some reluctance to change by the end of the meeting after the discussions. But they worked well in September in pointing to a very gradual ascent in rates once the tightening was underway.
Equally important, there seems to be serious consideration being given to enhancing the credibility of the rates guidance by adding a sentence in the statement with perhaps some elaboration in the SEPs narrative by noting the lagged time it will take to reach a neutral fed funds rate relative to trend in growth and employment. We also tend to think the idea of bolting onto the inflation threshold an additional 1.5% lower band to guide expectations on rate hikes could be effective, but it still seems to be generating little enthusiasm across the wider FOMC.
In any case, the statement is likely to undergo some serious editing to get its length down and to then make some room for the anticipated new additions to reinforce the credibility and increasingly greater reliance on rates guidance over the quantitative easing to provide the necessary accommodation at this stage of the recovery.
The Transitional Changing the Mix
While we do believe the FOMC is edging closer to a consensus on the need to reinforce its rates guidance and how it is likely to do so at the December meeting, the movement towards a consensus on the taper question seems far less clear.
The guidance is obviously closely tied to when the taper to the flow of bond purchases will begin, but the reinforcement to the guidance can and perhaps should proceed with or without a taper. The two policy instruments remain distinct, and work through differing transmission channels, as the chairman was careful to note in his speech last week.
Each has its own narrative as well, serving different purposes and different stages of the recovery. QE was always meant to help boost the momentum to a subpar growth still vulnerable to stalling or even turning south. Bond purchases were meant above all else to help ensure the unemployment rate did not level off at the wholly undesirable levels at the time.
Once the trend in unemployment is downward, however slow, much of the benefits to the bond buying has been realized; and the longer it goes, the higher the potential costs, largely due to the uncertainty of its transmission and effects on both financial market valuations and the real economy behavior. And the longer it goes, the bigger the balance sheet becomes, and the less likely the QE option can be wheeled out again.
Thus the need to change the mix between the two policy instruments towards the greater reliance on the better understood path for interest rates at this stage of the recovery. The rates guidance, in turn, should provide the more effective policy support as the recovery nears its much and long sought so-called “escape velocity” of self-sustaining growth.
In an ideal world, yields would be rising for the right reasons, as the recovery gathers steam, edging towards a more “natural” level — capped to a large degree by the anchoring of expectations on the short end through the credibility of the Fed’s forward guidance — that would promise a reasonably smoother adjustment to winding down the asset purchases.
Taper Reluctance, For Now
For now, there is wide agreement on the messaging that a taper is not a tightening and that the stock of total accommodation in the current open ended regime is going to end up somewhere around the $1.2 trillion mark by the time the bond purchases are wound down. If it is by more, it will not be by much, though that depends on how soon the Fed can feel confident in its forecasts on the pace of the recovery.
And that, as much as or perhaps even more than its concerns over a repeat of last summer’s market turbulence and spike in yields, seems to be making the majority of the FOMC still quite cautious in pulling the trigger on a first taper.
An especially strong Nonfarm Payroll number in the first week of December is likely to go a long way to setting market expectations and pricing for a taper, something the FOMC will not ignore. As we noted previously, if the market offers the FOMC a free hand in fully pricing in the taper and what seems to be the taper is not a tightening messaging, it will be hard to let the moment pass.
But it must be said a majority of the FOMC, albeit a slim one, will still be reluctant to begin the taper even if certain the markets are braced for it. For many, there just isn’t going to be all that much difference over when to begin tapering over the course of the often cited “next few meetings” in the total stock of accommodation or to the uncertain risks in possibly stoking asset bubbles.
But the more important trigger to the taper may be in the still uncertain outlook of a recovery that still looks just shy of the acceleration to self-sustaining growth. A dissipating tailwind to the housing recovery would raise eyebrows around the Fed system, for one, even if the headwind of fiscal drag is likely to fade next year.
Even if there is little to no tweaks to the central tendency forecasts at the December meeting, the level of confidence around those forecasts doesn’t seem to be especially high or not high enough, at least for now with the meeting three long weeks away.