Fed: Rates, Neutral, and the Balance Sheet

Published on April 7, 2017

The market looks to have taken this morning’s Non-Farm Payrolls in stride, and we certainly don’t expect it will be moving the Federal Reserve away from its current policy path either, though by all accounts it is still quite hawkish relative to the market’s resistant, reluctant pricing.

We in fact would not be surprised if a key thread to Chair Janet Yellen’s remarks this coming Monday afternoon is an accent on the pivot she and a majority of her Federal Open Market Committee colleagues have taken towards the quickened pace in both rates and balance sheet normalization now that the economy looks to be so near maximum employment and mandate-consistent inflation levels.

Going into this weekend, then, here are a few points as prologue to what we think will be the Fed‘s policy narrative through the coming months:

*** It should be fairly safe to repeat that we believe the base case is for two more rate hikes this year, three in total, and that, on balance, we think the FOMC is leaning to a June rate hike to maintain its maximum rate policy options in the second half of the year (SGH 3/21/17, “Fed: Upward Tilting”). A fourth rate hike this year is likely being kept in reserve as insurance in case inflation picks up faster than expected. But we also suspect the internal stirring to get going on balance sheet policy, and its assumed tightening effects, is one reason the March median 2017 rate dot plot was kept to three, instead of slipping to four. ***

*** On the balance sheet, we believe an FOMC majority wants the policy rate up to at least 1.5%, or halfway to the longer run neutral estimates, and ideally nearer to 2%, or the estimated effective neutral rate, before they would feel fully comfortable in ending the current reinvestment policy. Getting the policy rate into this “neutral zone” — with all that it would qualitatively affirm about the sustainability of growth and inflation — is seen as a safeguard against downside risk in a falling neutral rate once the balance sheet shrinkage is underway and is probably the defining marker to the “well underway” guidance for when to begin the long-awaited portfolio normalization. ***

*** Although we were previously skeptical, we now believe that if the data stay on track to the forecast this year, the end to reinvestments could indeed come before year-end as so many FOMC members have attested. To get there, the FOMC is likely to finalize its revised Exit Principles and Plans by its September meeting, and before then, use the template of the long messaging runway to the 2015 rates lift-off, using speeches, staff papers, and discussions in the Minutes along the way, to accent its non-policy signaling nature to minimize any market volatility by the time the end to reinvestments is underway by November or December this year. ***

*** The portfolio normalization preparations are only at their earliest stages, but the Committee consensus seems to be quickly coalescing around a well messaged “gradual, passive, and predictable” pace, no MBS sales despite an eventual return to a ‘treasurys-only” portfolio, and that the portfolio normalization should be secondary to rates as the primary policy tool. The FOMC also seems to lean towards an initial “phased” reduction to limit the risks of an excessive tightening, and for a “pause” in rate moves during the initial phase, under an operating framework requiring a “large” rather than “minimalist” balance sheet whose terminal size will not be known at the beginning. ***

We would caution that considerable risks will hang over the Fed‘s best-laid plans on its current rate path projections or before a single bond rolls off the balance sheet: obviously for one, the economy’s above trend growth could slow or accelerate, bringing its balance sheet plans to halt or bringing rate hikes forward; for another, the Fed‘s messaging on its balance sheet policy options so early in the decision process could complicate its signaling on removing monetary accommodation due to the uncertain effects on the yield curve and term premia, and; it certainly adds to the general confusion that more often than not greets the release of the quarterly rate dot plots.

More ominously, the Fed‘s portfolio normalization ambitions may also collide with what is likely to be intense speculation by this fall over Chair Janet Yellen’s possible succession, and the influence of three new Governors to the Board. The uncertain effects of Fed balance sheet policy could likewise overlap and further add to market volatility amid what we suspect will be an extended political uncertainty on Capitol Hill with delays in passing tax reform legislation, the FY2018 budgets, and even the debt ceiling.

Indeed, we can’t help but think of the sage advice of the boxer Mike Tyson who so famously cautioned that “everyone has a plan, until they get punched in the face.”

Singing from the Same Hymnal

Whatever can be said of the Fed these days, FOMC members have been nothing if not unusually consistent in their policy messaging since their March meeting rate hike, essentially singing from the same hymnal: an economy that looks on track to maximum employment and 2% inflation, and the need to quicken the pace of rate normalization from the glacial pace of 2015 and 2016 (see SGH 3/15/17, “Fed: “The Economy is Doing Well”).

We suspect Chair Yellen shares the view laid out by Fed Vice Chairman Stan Fischer who noted in his low key fashion a week or so ago after the March move that two more rate hikes this year “seems to be about right.” And although the market took New York President Bill Dudley’s remarks last Friday as dovish for reasons we cannot fathom, he too mapped out a fairly hawkish policy path to remove monetary accommodation through rate hikes and the eventual balance sheet reduction.

Rounding out the broader Committee voting consensus (ignoring the lone dissent for now), to its more hawkish end is Boston’s Eric Rosengren, arguing for even that third additional hike, or four this year, while anchoring the dovish caution on the other end of the Committee spectrum is Chicago’s Charlie Evans, who would be willing to go along with the two additional hikes, but who remains skeptical the data will warrant that fourth hike this year.

But the point is that there is a fairly remarkable, narrowed policy consensus across the FOMC right now that we think is tilting unmistakably hawkish, and we suspect is not entirely taken on board by a fixed income market whose muscle memory may still be toned by the years of the Fed‘s heavy overlay of risk-averse caution in moving off the Zero Lower Bound in 2015 and 2016, not to mention all those prior years of the lower for longer messaging that seems to have worked only too well.

But what the market is failing to digest is just how much the Yellen-led Fed has pivoted to a quickened pace of its policy normalization strategy, both with ratesand soon with its QE-stuffed balance sheet, now that the economy has been so methodically nurtured back to what is effectively maximum employment and mandate-consistent inflation levels. Everything the Fed is messaging these days is best seen through the prism of the twin mandates

The Fed, then, seems at ease with a further downward drift in unemployment below its 4.8% new longer run levels — which we guess is a good thing since it just popped down to 4.5% — and likewise, it is equally nonplussed if the core inflation rate temporarily overshoots its 2% target. But otherwise our sense is that a sustained crossing of a 0.3% mark, either below the median longer run unemployment rate or over the 2% inflation target, would be too much of a good thing.

The FOMC majority, in other words, seems to have concluded it may or may not be able to dampen down the excesses without pushing the economy into a recession, and therefore the more cautious approach is to pick up the pace of removing monetary accommodation, particularly amid what they see as near term risks that are tilting to the upside.

“This upward policy path will help prolong the expansion, not curtail it,” so says Cleveland’s Loretta Mester.

Getting to Neutral

So assuming as always the data stays on track to the forecast for steady above trend growth — and as indicated in the March meeting Minutes, a delay in any Trump fiscal reflation effects until 2018 — the next rate hike under the base case scenario is likely by summer, either at the June or late July meetings. We think, on balance, the FOMC will lean to a June rate hike to maintain maximum flexibility for rate policy in the second half of the year just in case, for instance, that fourth rate hike is needed after all.

But we think the crucial element to this base case rate scenario is a Committee majority ambition to get the policy rate safely up into what we could call a “neutral zone” of at least 1.5%, a benchmark of sorts as half way to the estimated longer run neutral levels, and near to 2%, the Fed‘s best estimate of the effective neutral rate.

To be sure, there is hardly any real precision in these estimates of neutral, and the Fed tends to reverse engineer from the data to get to its estimates of the neutral rate. But we think this sense of rates within this neutral zone is nevertheless a key benchmark to where the FOMC majority would feel most comfortable in meeting the “well underway” qualitative threshold to the long-awaited last stage of policy normalization in ending the reinvestments.

Chair Yellen and her Committee colleagues have often stated rates need to meet this “well underway” threshold in order to have enough cushion to respond to a downside shock by easing rates. Indeed, in the March meeting Minutes, there were quite a few participants agreeing to the principle that the FOMC should ease rates back down to the effective lower bound before resorting to another go at large-scale asset purchases.

But we are also struck by the concern that has surfaced from time to time, and which as we recall in the Minutes had come up in the November meeting when the FOMC discussed a staff paper on the future operating framework, that a balance sheet reduction is also likely to reduce the neutral rate.

By how much and how quickly is unclear and probably unknowable until the balance sheet reduction is underway. But the working assumption is that just as the QE programs worked primarily by reducing the term premium, the reverse is likely to be true as assets roll off, with credit spreads and term premiums on the rise again and, in effect, reducing the estimated neutral rate. And if those spreads widen, the overnight rate that will bring overall economic conditions into equilibrium should go lower.

But the last thing Fed officials would want is to underestimate the severity of the effects of shrinking the balance sheet and to be pushing the neutral rate down while driving the policy rate up. That could translate into an outright tightening well before the economy could absorb it and potentially derail the recovery after all these years of so laboriously shepherding the economy back to maximum employment and mandate-consistent inflation levels.

So that’s all the more reason to be as far away from the Zero Lower Bound as possible before introducing the uncertain effects of balance sheet normalization by starting to shrink the System Open Market Account’s $4.228 trillion in assets.

“Gradual, Passive and Predictable”

In line with the cautious style of the Yellen-led FOMC, Fed officials have repeatedly stressed a trifecta for the main guiding principles of the portfolio normalization strategy.

First, it will be gradual in a long roll-off of maturing assets over three to five years rather than a quickened pace of reduction that would include outright sales, and it seems, is likely to include an initial phase of phasing the run-off of maturing assets to smooth the monthly pace of assets rolling off, in part to limit the risk of a too rapid contraction that dislocates the markets.

There are details still to be worked out on that smoothing effort, one of which is whether the re-investments in some months would be rolled over into shorter maturities rather than simply in proportion to the maturities of the Treasury’s auction schedule.

Second, the portfolio normalization will be passive, kept to the background, and stripped of any policy signaling intentions, with rates to remain the primary policy tool. As we understand it, it would in fact be difficult for the Fed to use its balance sheet reductions as a policy tool when the ultimate impact will be largely dictated not by the Fed, but by Treasury in how it opts to adjust its own debt issuance and average maturity management.

The gradual shrinkage of the balance sheet, though, will obviously have a tightening effect, and will be incorporated into the Fed‘s rate decisions as one of the many factors affecting financial conditions.  That likely, but uncertain tightening effect also lies behind the logic of a probable pause New York FedPresident Dudley cited again earlier today as a “little pause” both to protect an unintended excessive tightening, and to make it “cleaner” for the Fed staff in assessing the impact on market conditions in a balance sheet reduction.

And finally, the portfolio normalization will be predictable in that its path and pace will be extensively telegraphed, using the template of the long messaging run before the equally momentous rates lift-off in 2015. By the time we think the new Exit Principles and Plans are unveiled, probably at the September FOMC meeting, there is likely to be few if any in the markets who are done with reading and thinking about it. A redux of the taper tantrum it won’t be.

One final point about the unfolding balance sheet strategy is that we suspect the FOMC will end up with a larger balance sheet than the “minimalist” balance sheet of mostly currency in circulation, required reserves, and a limited total of excess reserves and a return to the reserve-scarcity based system of the pre-crisis era and a Fed funds point target. That, for now, is the formal objective first mapped out under the Exit Principles in June 2011 and revised in September 2014, to bring the balance sheet back to a “normal” size defined as the “smallest levels that would be consistent with the efficient implementation of monetary policy.”

That said, we suspect the FOMC majority is already moving towards the merits and low volatility of operating with a much larger balance sheet, with plentiful excess reserves to keep the financial system liquid with safe assets presented in a staff paper for the Committee’s discussion on operating frameworks at the November meeting last year.

Instead after the extensive discussions in November last year about the future operating framework, the FOMC majority does seem to be leaning strongly towards the merits and low volatility the staff argued for in an operating framework built around a much larger balance sheet with perhaps as much as $500 billion in excess reserves on the balance sheet to keep the financial system liquid enough to meet the new higher regulatory demands for high quality safe assets.

And in any case, the Fed will probably start its portfolio normalization by ending reinvestments before it knows its ultimate end or terminal size, as it may not know the optimal operating framework until a few hundred billion dollars of excess reserves are extinguished. By then a better picture will come into view of how the money markets and how well policy execution will operate in the new post-normal financial markets.

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