The string of speeches by Federal Reserve officials this past week, in the wake of the Federal Open Market Committee’s March meeting madness, point to what we think are likely to be four or five intended policy messages takeaways in the coming weeks.
The short version of those are:
*** That the long awaited lift-off in rates will be “re-centered” into a range between April and the fourth quarter of next year with the Committee consensus moving towards the middle of 2015, as early as June and, for our two cents, probably leaning to September 2015;
*** The emphasis as the Committee consensus takes hold will be shifting from the timing of the lift-off to the very gradual trajectory of the rates seen by a majority of the FOMC once the tightening is underway, which is why the inclusion of the “below normal” sentence in the statement was so important;
*** The policy path being mapped out in the guidance is a finely balanced one between the angst over the persistence of low inflation and the concerns over stoking asset bubbles, each monitored risk acting as a counterweight to the other in the Committee consensus. But the data and revisions to the forecast are likely to tilt that balance one way or the other as early as the September 2014 meeting;
*** For all its disconnect at times to the statement, the SEP dots plot nevertheless provides valuable contextual information about the assumptions that go into shaping the formal (voted) guidance. The SEPs are likely to see further refinements through this year in parallel to the further evolution of the forward guidance as the FOMC moves towards the revisions to the June 2011 Exit sequencing principles.
*** Even under the optimal control framework, the rate trajectory as evidenced in the Summary of Economic Projections “dot plot” is dynamic, adjusting to the changes in the central tendency forecast on growth, unemployment and inflation, and should almost by definition be edging upward as the economy moves closer to trend.
“Re-centering” the rates lift-off to mid 2015
By now, it should be obvious that Chair Yellen did not intend to hawk up the policy messaging takeaway from last week’s statement with the reference to “six months” in explaining the time frame to a “considerable period.”
That said, Fed officials since then and in the weeks ahead will not necessarily be “recanting” or strictly “walking away” from the six months from the end of the taper to a first rate hike. That is because if the data runs ahead of the projections of the central tendency forecast, there is no particular reason the long awaited lift-off couldn’t come as early as the April 2015 FOMC meeting. It is just that it is unlikely.
That, by the way, will be worth bearing in mind if the second quarter numbers start to come in with a snap-back in growth as is widely expected. While the market may take the better looking number to catapult forward rates pricing, the FOMC is instead far more likely to look past the stronger spring numbers just as they did the recent weaker than expected snow-swept data to stick to its forecast of 2015 growth on one side or the other of 3%.
Instead, as we wrote last week (SGH 3/20/14, “Fed: Um, About those Six Months”), we expect Fed officials essentially to “re-center” the expectations over a first rate hike by placing it within a longer range running from as early as spring 2015 to as late as the fourth quarter of next year (with some throwing in early 2016 for good measure). In the end, the idea is to push market expectations to the middle of 2015 as the most likely point for the first move in rates from the current 0-25 basis points.
Lift-off then, for now, could be assumed to be coming at the June meeting, or as we think based on nothing more than a gut feeling, leaning to September 2015.
A shift in emphasis to an expected gradual trajectory
At the same time as putting the likely timing of lift-off into a narrow range in the middle of 2015, Committee members have been and will continue to increasingly put their emphasis on what they think will be a very gradual trajectory in the path of rates once the tightening is underway. Some of the reasoning, one suspects, is a bit of bait and switch to get off the sole focus on when the first hike is coming.
But the likely path and the reasons behind it are much more important to the outlook for the recovery than the timing to a first hike. That is, if the Fed can allay market concerns over the first hike timing by presenting a credible case that the hikes in any case are far more likely to come in a gradual gradient, it may go a long way to minimizing the risk of a spillover of market volatility into derailing the recovery.
What’s more, the reason why the Fed should and can adopt a gradual trajectory is crucial to the credibility of that projected path. Former Chairman Ben Bernanke previously noted vaguely defined headwinds that are translating into a lower level of rates to keep the economy at equilibrium between full employment and anchored inflation and inflation expectations, be it balance sheets still being repaired or the time it takes for bank and consumer behavior to readjust after years at the zero lower bound and low savings rates.
And that, in turn, dials back to the most important change in the guidance from Numerical Thresholds to the descriptive qualitative guidance last week, the inclusion of the sentence: “The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”
That was also the most hotly debated point of the meeting. Not all Committee members agree with the odds on a likely gradual path, and still suspect the Fed may just as easily end up needing to quicken the pace of the tightening to dampen a spike in lagged inflation after all these years of extremely accommodative monetary conditions. Others thought even if it is likely to be gradual, there is no point in broadcasting that likelihood in the guidance, which becomes more of a commitment once in the formal statement, and thus taking away some of the Fed’s discretion to respond to unforeseeable conditions once the Exit is finally underway.
But those objections are for now pushed into the background, for the statement is the primary vehicle for the FOMC’s forward policy guidance as Chair Yellen was at pains to stress in last week’s meeting, and that assertion of a “below normal” neutral level of interest rates will dictate the assumed policy path until revised or refined in future statements.
The path between persistent low inflation and high asset price inflation
Along the same line, there has been no small amount of attention given by several Fed officials, most thoughtfully articulated by Governor Jeremy Stein, to the risks of stoking asset bubbles and a reach for yield in such a highly accommodative policy. But at least in the near term that hawkish tilt is being offset by an equal caution over the persistence of low inflation that would for many warrant continued accommodation. In other words, there is a certain uneasy equilibrium in the current policy guidance that is carefully treading a path between these two closely monitored risks.
What is perhaps most interesting of all is the internal recognition that it is the stance and path of policy itself that is elevating these risks rather than external shocks. But in any case, both these concerns are balancing each other in the near term, but that could tilt one way or another before the end of this year.
Perhaps clear problems in asset levels will emerge that go beyond the pockets here and there that are the logical jurisdiction of macro prudential policies, but are instead threatening enough to stability that the “in all the cracks” tool of interest rate changes is called for. If that proves to be the case, a majority of the Committee led by hawks keen to move rates sooner whatever the reason, and an uneasy band of centrists may indeed press to move the first rate forward and start aggressively pushing back on the excessive risk taking behavior in their public remarks.
On the other hand, there is nearly as vocal if not equal in size number of Committee members who look anxiously at the persistence in low inflation. Yellen did insert into her prepared remarks last week a reminder (which may have been included to offset the below normal” sentence in the statement) that “monetary policies operate with a lag” — translation: don’t worry about the low inflation since when the inflation does come, it will come with a lag after all these years of easy policy.
But if that inflation doesn’t start to show up pretty soon, or worse near term inflation expectations start to dip, it is going to stir enough anxieties among many Fed officials already looking at the global nature of the persistence in low inflation that deflation risk will rise to the forefront of their public remarks and eventually make their way to the FOMC table and a possible policy response.
Indeed, bringing this balance of risks back to the lift-off, which way the data point in the forecasts, whether to the risks of real goods deflation or asset price inflation, will more than anything else probably dictate where the first rate hike will come in that re-centered lift-off range of mid-2015.
The contextual value of the dots-plot and coming revisions
First, for all the seeming disconnect between the statement’s dovish guidance and the apparent hawkish turn in the dots plot, the dots plots do provide valuable contextual information to the thinking and assumptions that ultimately goes into the primary vehicle for guidance in the voted statement. Most of the problems in crossed signals is the FOMC’s own fault, in the dots evolving into playing a role they were not designed to perform.
The dots emerged from the Communications subcommittee of a few years ago, and were mostly seen as a step up in the transparency and usefulness of the quarterly SEPs. They are, after all, simply putting dots to paper on what each of 13 different staff forecasts are penciling in as the appropriate policy path in order to achieve their growth, unemployment and inflation projections. But that is several non-transparent steps away from the debate and formal vote on what guidance should be put into the statement itself.
At the time, with rate hikes so very far away, the thinking was the dots would help to anchor lowered expectations for when those rate hikes would come. Perhaps though, the FOMC did not think through what would be happening as the time came closer to that eventual rate tightening.
Revisions to the SEPs and to how the dots are presented are likely, perhaps as soon as their next unveiling in June. For one, perhaps the individual dots could somehow be more directly linked to the forecasts on which they are tied, or perhaps the FOMC could even agree to a unified central forecast and dot plot, with room in the rest of the SEPs to present the individual projections or the ranges of the projections.
It is too early to guess how the effort will come out, but the point is the FOMC is painfully aware of the crossed signals that can open up between the statement and the dot plot. It will be the subject of numerous remarks and speeches in the run up to what is a likely attempt at a fix without losing the value in the dots as a secondary underpinning to how the reaction function is taking shape.
And finally, the dots can adjust upward even under optimal control
One last point, one that we have made on occasion in previous reports (see SGH 1/22/14, “Fed: Towards a Post-Threshold Framework”), even under the most dovish optimal control framework, the first rate hike and the trajectory of the rate tightening can and will be adjusting upward, depending on the progress of the recovery towards the assumed trend levels in employment and growth. So in that sense, that the cluster of the more dovish dots in the March SEP should disperse somewhat and drift upward to a higher median level is not all that surprising.
The central trade-off in the optimal control simulations — which have been a part of the staff preparations for the FOMC meetings for at least a decade — is faster near term gains in employment at the price of possible higher (but temporary) inflation down the road. It is a relatively easy trade to make when the output gap is clearly so large and the unemployment levels so high.
But as the headline unemployment rate drops closer to range, opening the door to the next layer of analysis over just how much slack remains in structural versus cyclical participation rates or the outlook for sustained wage gains, that trade off becomes less obvious and cost/benefit balance starts to tilt towards the costs rather than easy benefits.
Almost by definition, the projected rates and their path to neutral levels will start to drift upward. But the point is, this more dovish path and dot plot will still be running far lower than they would be under the more traditional Taylor Rule assumptions, which it must be said, would have been just short of a disaster if actually pursued these last few years.
That, in fact, can be seen in the changes in the projected optimal control rate paths laid out in the two speeches Yellen gave as a vice chair in June and November 2012. In part because unemployment was falling faster than originally assumed, and most of all, inflation did not turn upward but fell instead, the path in November flattened out relative to June into the more gradual path that has now, as a general assumption, made its way into the formal statement.