Fed: Plus ça Change

Published on October 20, 2014

For all the brutal wild swings in the markets last week, we suspect it will all have the barest of an impact on the outcome to the Federal Open Market Committee’s October 28-29 meeting. The more things change, it seems, the more they stay the same, at least for now.

*** Despite the public suggestion by one Committee member to the contrary, the FOMC is highly likely to end its bond purchases this month. A Committee majority seems unlikely to share the immediate concern that falling market inflation expectations warrant more bond purchases, and believe the signaling confusion in changing the purpose of QE from the labor market to inflation would be more trouble than it’s worth. A sentence may be added, though, noting a bond purchase program could be resumed if warranted. ***

*** It is too soon for the cross currents of the stronger dollar, lower oil prices and market volatility to have a significant impact on the forecasts being prepared for the meeting. The FOMC will instead work from its projected near 3% pace in growth and a gradual decline in unemployment and rise in inflation back to mandate-consistent levels. Committee concerns over the dollar and market volatility, as well as the decline in market inflation expectations, are likely to be addressed in the descriptive first paragraphs of the statement. ***

*** Where the recent volatility may leave its mark is in a Committee desire to avoid any own goals of mis-interpretation to changes in the guidance. While we suspect the market is putting far too much weight on its policy significance, we now think on balance that the “considerable time” language will probably stay in the statement. Punting guidance changes to December allows both for more time to assess the data and to potentially incorporate the eventual changes into a new guidance framework being weighed for next year. ***

QE: To Be, or Not to Be

St. Louis Fed President James Bullard caused quite a stir and apparently helped fuel a stock market rebound last Thursday when he made the case the FOMC may want to consider extending the $15 billion in bond purchases for another two months until at least the December meeting.

While controversial, Bullard had a point in stressing the FOMC needs to keep an eye on falling inflation expectations and to weigh whether it may persist or foreshadow a turn south in the recovery. And in principle, the tapering of the bond purchases is not on a pre-set course, and the open ended nature of the bond purchase program was to give the Committee the option to adjust the purchases up or down, depending on the level of accommodation needed.

But a large majority of the Committee seem firmly opposed to any extension of the QE program. For one, the FOMC majority seem determined to move away from the balance sheet as a policy tool to rates as the primary policy tool. And while the statement may have said the taper since last December is not on any pre-set course, the fact is for most of the FOMC, it damn well was. Indeed, the decision to maintain the size of the balance sheet by putting off the end to reinvestments until well after the first initial rate hikes is a case in point.

More to point, to extend the mere $15 billion a month remaining in the bond purchases would have no significance other than as a policy signal, but a signal about what? 

The current open ended program was explained to the public and the markets — and sold internally to skeptical Committee members — as ongoing until a “substantial improvement” in the labor market. While there remains “significant under-utilization of labor market resources,” there is little question there has been just that substantial improvement in the headline unemployment rate falling to 5.9% from the 7.9% level when the QE program was introduced in September 2012.

But if the reason to continue with the remaining $15 billion a month in bond purchases was now shifted from stoking labor market improvement to stem falling market-based inflation expectations, most Committee members are likely to be deeply skeptical the Fed can be so narrowly redirect its messaging so suddenly to specifically address the lower market inflation expectation without it being taken as doubts over the durability of the recovery.

Indeed, there is a sense it could only worsen rather than clarify the Fed’s struggle to define its reaction function to its “data-dependent” policy path.

Worse, there is a somewhat unspoken Fed concern that Bullard’s intervention with a proposed extension of the QE purchases is being mistaken as a knee-jerk response to the swoon in the stock market — which in fact seems to be exactly how many stock market pundits are already taking it — as a new “Yellen put.”

Our sense instead is that for the FOMC majority, including the doves who might favor continued bond purchases, the better course on QE will be to wind down the program as has been scripted for months. We do think, though, the Committee may decide to leave the option open that bond purchases could always be renewed down the road if the need is seen in a worsening outlook growth, or indeed, if the lower market pricing for inflation spills over into broader measures of inflation expectations.

On that score, despite the market’s anxieties over the downward drift in its pricing for inflation expectations in the Tips spread or the five year/five year forward rates, the Fed is taking the market pricing with a grain of salt.

It will be relatively unmoved unless the market pricing is coupled to a downturn in the recovery or shows up the real economy measures of inflation expectations such as the University of Michigan data, the Blue Chip forecasts, or the Federal Reserve Bank of New York or Cleveland measures of inflation expectations.

And those remain fairly well anchored for now at around 2.8-3.0%. That leaves the Fed’s likely response limited to acknowledging the market’s inflation expectations pricing in the descriptive paragraphs of the statement rather than changing the more powerful guidance language, much less the bond purchases. Either of the latter would be potentially signaling a major shift in policy that could quickly become difficult to manage.

Forecast Offsets

Likewise, our sense is that the impact of the rise in the dollar, the overall market volatility, and even the plunge in bond yields beyond anything the Fed has anticipated, will have only a limited impact on the forecasts being prepared for the October meeting. It is for the most part just too early for any of the recent developments to move the needle much in the central tendency projections.

But for now, on balance, the tailwind of lower oil prices boosting potential consumption and demand, and lower interest rates that translate into less debt burden and more attractive mortgage rates, should modestly offset the headwind of the stronger dollar and stock market declines, so a net plus for the most part.

That assumes, of course, that the stock market gyrations do not persist and trigger a confidence shock and a hesitation to spend. And while lower oil prices should translate into lower gasoline and home heating oil costs, it will also push headline inflation even lower and potentially deepen the anxieties a deflation-prone US could start looking like Japan or Europe before too long. The current pricing and yields are certainly pointing in that direction.

Still, the lower headline inflation will not necessarily spill over into the more important core inflation measures, and we always thought at least, the Fed builds its core price projections around its estimates of the output gap and broader inflation expectations than it does either market-based measures of inflation expectations or headline inflation.

And while the uptick in core inflation since last spring seems to have now faded, the Fed is still expecting core measures to resume a gradual climb back towards 2% when wage growth finally starts to climb on the back of headline unemployment falling to 5.5% or lower.

It is more likely the Fed staff will need until the December meeting to sift the signal from the noise in the data to judge just how much confidence they have in the underlying strength of the recovery, and to discern the balance of the tailwind versus headwinds of the last few weeks. And that, in turn, suggests a fairly uneventful October meeting and statement.

A Punt on Considerable

On that score, we suspect the balance of the FOMC is now leaning towards keeping the “considerable time” language in the statement next week. There was certainly some hope the way to do so would be cleared by the recent efforts to neuter the phrase of its six month connotations to lessen the risk of potential mis-interpretation. But we are not so sure that has really worked out all that well.

And in any case, no clear consensus seems to have been forming in the weeks since the September meeting. And now in the wake of last week’s market gyrations, there seems to be a strong desire among many Committee to simply avoid changes to the guidance that could trigger volatile moves in the market pricing on a first rate hike – especially when the FOMC itself is hardly certain of the most likely lift-off date other than pointing to sometime in mid-2015.

So the path of least resistance next week may be to leave the considerable language intact, without a tether to an event-based anchor, and punted into December when the Committee will have the luxury of more time to assess the data and what it portends for next year’s outlook and the most appropriate timing to a first rate hike. Importantly, it would also give the Committee more time to weigh how to change the statement and guidance language to better fit with a framework better suited for next year when that lift-off date is drawing that much nearer.

Perhaps the Committee can move things far enough along to make that call next week, but the odds do seem now to favor putting off today what can just as easily be done tomorrow.

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