- The December rate hike remains all but certain; the rate dot plots should stabilize at existing levels, marking the peak of Fed dovishness.
- The impact of a presumed Trump Administration fiscal boost is likely to push the Fed’s rate projections upward, beginning as soon as March.
- The timing to actual rate moves will depend on inflation dynamics and the Fed willingness to run a “high pressure” economy. On balance, the Fed consensus may tilt more hawkish.
- The arrival of new Governors will be first felt on regulatory rather than monetary policy, but rate consensus may become more difficult, and the Fed’s policy framework may be challenged.
Financial markets have been flying since Tuesday, with the dollar surging, stocks rising, bonds yields spiking, and the probabilities pricing for rate hikes by the Federal Reserve rising sharply. In the wake of the dramatic election of Donald Trump as the next President of the United States, there is an unmistakable sense of a repeat episode of the market dynamics set in motion by the Reagan Administration in the early 1980s.
And with it, questions invariably turn to the Federal Reserve’s near policy path and its likely reaction function to the presumed changes coming in the policy mix, especially on the fiscal front. It is, of course, early days, but a few points are warranted.
*** In the very near term, the Federal Open Market Committee is still very likely to lift the federal funds target range by another 25 basis points at its December 13-14 meeting. Only an extended, systemic-threatening market volatility or a significant, sustained tightening in financial conditions would derail the Committee from its current path. If anything, the market pressures are in the other direction and if sustained, the Fed could quickly find itself scrambling to temper the risk of another “taper tantrum.” ***
*** The Fed will find itself under unfamiliar political pressures next year. For one, there could be up to five new appointments to the Board of Governors over the next 18 months or so, as well as several new District President nominations. Their selection will invariably reflect the influence and agenda of the new Republican White House. And that could complicate Chair Yellen’s consensus leadership style and strain the FOMC’s collegial decision-making process. On balance, the FOMC could tilt slightly more hawkish than dovish as previously assumed. ***
*** While its scale is likely to be uncertain through the first half of next year, the high likelihood of major tax cuts and higher discretionary spending is likely to force the Fed’s hand in accelerating the pace of its rate hikes. That will first show up in upward shifts in the rate dot plots as early as the March FOMC meeting, while actual rate moves will depend on the inflation dynamics, including shifts in inflation expectations, and the internal Fed debate over “temporarily” overshooting the inflation target. ***
In other words, our sense is that the terms of the policy debate within the FOMC will soon be shifting from how little to how much inflation will be tolerated. And one other point, in case it needs to be said, there is no chance Fed Chair Janet Yellen will be leaving her position before her term ends in 2018.
December’s Messaging Complications
In the late hours Tuesday night when a Trump victory was becoming apparent, the market’s initial reversal in pricing probabilities for a December rate hike was understandable in reflexively recoiling on the shock of new uncertainties.
But unless there is an extended period of financial dislocation and instability — which for now seems unlikely — or if financial conditions were to tighten considerably over the next four to five weeks, the FOMC remains most unlikely to be driven off course on the long awaited second rate hike in the policy normalization path.
The Fed’s long approach to the highly likely rate hike at the December 13-14 FOMC meeting is built around the data that in fact continue to confirm the “current course” of above trend US real growth and the steady tightening of the labor market. That, in turn, is underpinning the Fed’s confidence in the forecast for a slowly unfolding upward pressure on prices towards mandate consistent levels. Nothing in the election of Trump changes that path in the very near term.
If anything, the market pressures are now moving strongly in the other direction, with the surging dollar, stock markets, and rising bond yields. The question is increasingly not over the rate hike itself, but whether a market risk-on repricing, if sustained beyond a short relief rally, will complicate the Fed’s messaging around the near certain rate hike.
While we would not be surprised if the staff present alternative fiscal path scenarios in addition to a base case outlook built around current law and Congressional Budget Office assumptions, the December meeting is almost certainly too early for the forecasting process to incorporate the effects of any fiscal policy changes. That is because the scale of a fiscal expansion is simply too uncertain, or indeed, whether the politics of higher spending levels and tax cut ambitions will come off at all.
That in turn for the most part suggests any noteworthy upward shifts to the Fed’s December rate dot plots in the quarterly Summary of Economic Projections seem unlikely. Some districts may in fact still be catching up to the downgrades to the longer run neutral rate or to a shallower rate path that has marked the dot projections all this year.
But the market’s pre-emptive pricing across the yield curve in anticipation of the incoming Trump Administration’s fiscal policy ambitions will invariably precede the Fed’s own policy reaction and policy path projections. And if the market overreaches — imagine that! — on pricing in an expected higher inflation or in excessively steepening the curve, the challenge to the Fed’s communications will be significant in something of a potential repeat to some degree of the taper tantrum difficulties.
That could make for a very fluid dynamic by the time of the December meeting, potentially disrupting the Fed’s messaging intentions to ideally frame a rate hike against a dovish backdrop of the very gradual pace of subsequent rate hikes on display in the rate dot plots.
It may require a carefully crafted sequence of Fed messaging to dampen excessive expectations in the run up to the mid-December meeting. For otherwise, a core objective behind the policy normalization strategy — to limit the risks of rapid rate hikes that either overshoot a near zero effective equilibrium real interest rate or cause severe enough market dislocations to derail the recovery in the real economy — could be at risk.
A key takeaway, then, amid the complications of the Fed messaging in December is this: that the years of the Fed’s rate projections collapsing towards the market’s extremely dovish pricing will in all likelihood be coming to an end, with the December meeting probably marking the peak in the Fed’s dovish signaling.
Indeed, we would wonder how soon or to what extent after all these years of the market pricing deeply under the Fed’s own assumed rate trajectory, that the market pricing moves up to or even exceeds the Fed’s median rate hike projections?
Rates in a “High Pressure” Economy
As opposed to the forecast-based rate projections of the quarterly SEPs, we suspect the actual timing to the third and subsequent rate hikes next year will depend on the Fed’s evolving understanding of inflation dynamics, how inertial it may continue to be under various fiscal scenarios, and the movement in inflation expectations.
Perhaps most crucially, the pace of rate hikes next year may depend on the outcome to the internal debate over Chair Yellen’s “plausible ways” scenario of running monetary policy in “high pressure” economy for a while at full employment.
In many ways, the long sought helping hand from fiscal policy would be coming several years too late. The government shutdowns, debt default threats, and the cuts to federal spending in the years in the wake of the 2010 Tea Party wave denied the economy a key component of growth. While fiscal drag gave way to a more neutral effect by 2014, it still arguably forced the Fed’s hand with the launch of the QE3 open-ended bond purchases at the end of 2012 and the highly accommodative forward policy guidance.
But now the Fed may have to be careful for what they wish for, since any yuge Trumpian fiscal push comes off in some scale, it will be coming when the economy is already very near full employment and inflation is showing clear signs of edging up to “within hailing distance” of the Fed’s inflation mandate.
So while the Fed will welcome playing a second fiddle, supportive role to the lead play of fiscal policy in driving a higher US growth rate — and perhaps in time, a transformative higher trend growth — the internal debate is very likely to shift as early as the January FOMC meeting to a more defensive posture, from how little to how much inflation will or should be tolerated.
We always suspected Chair Yellen had in mind a scenario of growth running a bit stronger and the labor market tightening a bit faster than the Fed’s projections at the time when she presented her research question: are there merits to letting the economy run hot for a while in order to probe how low unemployment can go or how high wages can climb before an excessive overshoot of the Feds 2% target for mandate-consistent inflation levels threatened?
It is far too early to speculate on how that internal debate will ultimately evolve, but for now, we suspect the delicate balance of the consensus within the Committee is going to steadily tilt towards a more hawkish answer in the reaction function to signs of rising inflation coming against the backdrop of a major fiscal policy push of some scale.
The New Committee Arrivals
And one last point, the arrival of new appointments to the Board of Governors through next year may further complicate the policy decision making process. We would be reluctant to speculate on the possible nominees under a Trump White House, and we suspect their early impact will be limited in any case on the rate policy debate, their influence perhaps being felt more in the Fed’s regulatory and supervisory role.
We in fact tend to dismiss the notions that a President Trump or his advisors will be seeking to crudely sway the Fed’s rate policy decisions. The new appointees to the Board could all prove to be just as dovish as any Clinton appointees could have been.
The issues that we think may loom for the Fed as soon as next year are two-fold. The first is in the potentially disruptive challenge for Chair Yellen in her style of forging a policy consensus and mapping out a methodically prepared rate path, whether quickened or slowed.
And second, perhaps more fundamentally, new arrivals to the FOMC — perhaps being drawn from outside the dominant mainstream macro economic policy thinking, and coming with the likely dramatic shift in fiscal policy or turns in the global growth picture — will all tend to bring into focus new questions over the Fed’s core operating framework and assumptions, be they about the neutral interest rate, reliance on the Phillips Curve trade-offs or slack based models of the economy, the merits of overshooting the inflation target, or even the Fed’s operating independence.
However successful the Fed is in managing the next transitions in monetary policy and the sustained growth in the US economy, the years since the 2008 crisis may end up feeling like they were the easy part.