Against the backdrop of the widening divergence between market pricing and the Federal Reserve’s “data dependent” path towards policy normalization, three issues seem key to us for the consensus slowly taking shape within the Federal Open Market Committee as they head into their first of the year meeting in about ten days.
*** First, the deeply more skeptical market sentiment notwithstanding, an FOMC majority remains upbeat on the US outlook. Domestic fundamentals look sound, with demand strong enough to more than offset the drags on growth from abroad, due to solid job growth, the absence of fiscal drag, still highly accommodative monetary policy, and the major boost from lower energy prices. Even wages, despite the aberration of last week’s NFP earnings print, are still likely to gain traction as the labor market heals. But there is unlikely to be any firm evidence of the downward pressure on inflation reversing or moving back towards its 2% target before summer and certainly not by the spring. ***
*** Second, the FOMC intends for now to “look past” the near downside price risks, with June still seen as the base case for a rates lift-off. Slippage to September (SGH 1/7/15, “Fed: Two out of Three Ain’t Bad”) has, however, been looking increasingly likely. A consensus for a June hike will be difficult with the risks and optics of hiking amid such weak inflation numbers, especially if the decision and signaling would have to be made at the March meeting or April at the latest. But the FOMC’s determination to get off the Zero Lower Bound should not be undervalued, and assuming the data cooperates, it is unlikely a first rate hike will be delayed to later in the year or 2016. ***
*** And third, the FOMC’s rate decision will invariably turn not on the data but a tough risk management trade-off between going too early and undercutting the recovery or unanchoring inflation expectations to the downside, and waiting too long and risking near term destabilizing market “elevated sentiments” or an excessive inflation overshoot further out the forecast horizon. To avoid raising rates too sharply, we think getting to a consensus on a very gradual pace of rate tightening and how to communicate it — one that is likely to be marked by extended pauses over several years — will keep lift-off within the June-September window, regardless of low inflation. ***
span style=”text-decoration: underline;”>A Widening Divergence
Under its current projections, the Fed sees no real reason why the recovery should not continue as its current pace with the boost from lower oil prices, the absence of fiscal drag, and still highly accommodative monetary policy. And at worst, even if it should falter, drifting back to the near 2% pace of the last few years, it would still be higher than trend potential to create an ongoing albeit modestly lower pace of jobs.
So as long as US domestic growth remains intact, the downward pressures on prices will also prove to be transitory and fading by the second half of the year.
But it is as though the very same data the Fed is taking into its forecasting models as a net stimulus to the economy — be it the lower oil prices, the lower yields, even the low inflation which lifts real wages — the market is interpreting as a negative feeding into the narrative of a global slowdown and a deepening disinflation if not deflation that inevitably spills over into the US economy.
Just within the last week, the market has all but priced a rate hike out of this year, and even more alarmingly for the Fed, has peeled back most of any tightening at all through 2017. It has been a driving sentiment to market expectations ever since the gloominess over Europe at the September IMF meetings. And unless corrected in the coming months, this market gloom relative to the Fed’s more optimistic forecasts for the US recovery is inevitably setting up a potentially nasty showdown where either the Fed or the markets will have to blink later this year.
Fed officials obviously see the same weak numbers abroad and the strength in the dollar, and staff members are weighing how much of the more recent drop in oil and other commodity prices might be due to demand weakness rather than just over supply or a market overshooting until a new equilibrium is found. So any sane Fed official will acknowledge the risks, especially the global nature of the downward pressure on prices that points to an ongoing deep demand deficit.
And while the FOMC majority are taking neither the market pricing and such low yields as a harbinger of recession nor the five year/five year break-evens as a signal of sustained low inflation or deflation on the horizon, the more dovish among the FOMC are nevertheless alarmed by what the market may be signaling about the persistence in low inflation or that it may become self-fulfilling and may soon pull inflation expectations down in the real economy.
Likewise, the absence of any upward wage pressures despite the headline unemployment rate now down to 5.6% — even if the latest average hourly earnings print is seen as an anomaly — is prodding several Committee members to nudge their projections for longer run unemployment down to 5% or lower in the upcoming March Summary of Economic Projections.
With such obvious concerns over the risks in persistent low inflation, and having missed its inflation target for so long, a core of the more dovish Committee members, with some sympathy from centrists, are arguing there is simply no need to rush to a rate hike, and to keep the policy rate at the current 0-25 basis point fed funds target until there is confirming evidence in the data to bolster confidence in the forecasts that core inflation will indeed begin turning up towards its 2% target, however slowly.
Evidence of Inflation Turn Unlikely Soon
The catch to the dovish case, however, is that the evidence of core inflation turning upwards is unlikely any time soon. Headline inflation is all but certain to go negative in the coming months due to the effects of the 50% plunge in oil and gasoline prices, which in turn, will inevitably drag core inflation measures down with it, albeit by far less.
But the issue is that while the drop in headline inflation is likely to be sharp but short — assuming oil prices at least stabilize or do not continue to fall so steeply — the lower core inflation measures will persist for a lot longer as the second round effects of the lower energy costs make their way into the non-energy sectors of the economy. That trend may persist through at least the summer if not longer; after all, that is the inertial nature of core inflation
All of this is, for the most part, a “good” disinflation, and if anything else, makes the still lackluster wage growth the Fed expects this year of 2% to 3% feel even better and equal in effect to the 4% wage growth sought on the assumption of a nearer 2% inflation rate. And that real wage gains would be on top of the assumed steady job creation gains that will between them add to aggregate domestic demand that more than offsets the transitional drags of the energy sector adjustments to the new oil price equilibrium.
But still, if it is firmer evidence of a turn in the inflation measures the Fed is to wait for before beginning its much-sought policy normalization, it may be waiting for a long, long time.
Slippage to September Increasingly Possible
As we have noted previously (SGH 10/3/14, “Fed: A “Patient” Reaction Function”), low inflation in itself won’t preclude a rate hike as long as real growth and the gains in the labor market remain intact and, crucially, inflation is higher in the forecast — it is the inflation forecast that will drive the policy decision, not where inflation is in the lagging indicators.
But that of course begs the question of whether the majority of a voting FOMC will feel confident enough in those forecasts without any evidence in the data that core inflation is rising however slowly; the path, after all, is supposed to be data dependent.
That is why we suspect the consensus on the balance of the risk management tradeoff for a June hike will be difficult to achieve. That is especially the case since the decision would have to be made at the March meeting, not June, or at the latest, the April non-presser FOMC meeting, in order for the FOMC to signal in its forward guidance that a rate hike is imminent. The optics of signaling a rate hike looms with core inflation still at barely 1% or lower is going to make more than a handful of Committee members reluctant to pull the rate trigger in the spring.
Recent remarks by a handful of Fed officials still indicate that for many if not most of the FOMC, June remains the base case for a first rate hike, which had also long been our own assessment, in that June was the fulcrum around which the “sooner or later” language of the guidance has long rotated (SGH 9/23/14, “Fed: The Dots and the Trajectory”). And it could still happen, as the data may build to the point the decision can indeed be made by March or April.
On that front, the Employment Cost Index data on January 30, and the January NFP breakdown the following Friday will be crucial in shaping the Fed’s internal assumptions going into the March meeting. But nevertheless, we suspect the odds still point to some slippage seeping into the calculations on the timing to that first rate hike, with a tilt towards a more cautious September lift-off in order to bring round a firmer Committee consensus on such a watershed decision as moving rates up after six long years at the Zero Lower Bound.
A Gradual Trajectory
One last point we think important to note, and which may go a long way to keeping the rates lift-off within the June to September window this year, is how soon and to what extent the FOMC can get to a consensus on the likely pace and path of the tightening trajectory after lift-off, and how to communicate it. It will be the linchpin to bringing the doves on board to a first hike sooner than they are comfortable with, and to keeping the hawks happy that at least the path to normalization is finally underway.
Indeed, the tightening cycle the FOMC seems to be moving towards adopting as its base case could be marked by extended pauses and arc across several years, to at least 2017 or even into 2018, which would look neither like the rapid rate hikes of 1994 nor the measured pace of 2004.
The reasons are twofold. First, a near certain volatile market reaction to a rate lift-off looms large in the FOMC’s concerns. To avoid a market dislocation so severe it risks spilling over into the real economy, there is some thought that messaging an extremely gradual trajectory, albeit one that may seem sooner than expected relative to where inflation is, may lessen the damage and give the market even more time to adjust positions to the reality monetary accommodation is indeed being removed.
It echoes the analysis long presented by former Fed Governor Jeremy Stein on the linkages between the financial markets and monetary policy. And while he may have been a tad early in his assessments while Governor, there is a growing number of Committee members who now believe the “Stein moment” is approaching, and for those financial stability concerns to come into play with a larger role in the risk management calculations going into the rate timing, certainly on the margin.
And second, further out the forecasting horizon, a long tightening cycle should also serve to restrain the upward momentum of inflation that, once underway, may prove to be difficult to contain, like trying to turn a tanker around. Inflation is hardly a near term problem, and for most of the FOMC, it probably won’t be for another three years or so. But that the sheer inertial nature of inflation, once moving, may prove resistant to efforts to slow or cap it, is looming larger across the FOMC’s thinking.
Better then to start tightening conditions sooner to protect a long slow ascent that reduces the need for sharp rate hikes later on if inflation is indeed threatening to move too far or too long beyond the 2% target. And by simply working back from where they would like rates to be by some time in 2017, at or near neutral, it more or less puts the lift-off right back into the middle of 2015 and the June-September window the majority of the Committee has been messaging for some time.
The data may veer off the central tendency base case, or the markets may react badly or not at all, and as New York Fed President Bill Dudley has forewarned, it may lead the Fed to move more rapidly or even more slowly.
But those are the outliers to the base case scenario on the trajectory the Committee will be discussing at their upcoming January meeting and could become a consensus by March, paving the way for the decision on the timing to the lift-off, with or without the cooperation of the inflation, or for that matter, the market pricing.