More than half the Federal Open Market Committee will be flooding the zoomed air waves with public remarks this week, the high tide mark in the new communications wave being Chairman Jerome Powell’s twin testimonies tomorrow and Wednesday on Capitol Hill.
A few points as prologue on our expectations as to this week and the run up to the March 16-17 FOMC meeting:
** We expect Chairman Powell and his FOMC colleagues to stick close to the script since the January FOMC meeting: the recovery, though definitely promising, is still far from certain much less the labor market gains being widely shared, and a still subdued, inertial inflation is the greater near risk than “temporary” upward price pressures; that translates into a full throated support for an aggressive fiscal policy and for the Fed’s own optimal rates and balance sheet policy to firmly remain on a highly accommodative path.
** Drawing from the lessons of being on the wrong side of the taper debate in the spring of 2013 – then Governor Powell was among those on the Board pressing then Chairman Ben Bernanke for a premature exit from QE3 — we understand that Chairman Powell is determined this time to steer a highly accommodative policy messaging, with consistency and repetition, to carry markets through an expected inflation scare this spring and to prepare the wider public for a higher inflation and a hotter economy.
** That translates into Fed officials continuing to push back, hard, on near term inflation concerns, and affirming they will “look through” the widely expected pop in price pressures this spring. And they will likewise continue to shrug off the recent rise in yields, as well as the notion in some corners of the market that the central bank may soon intervene to put a lid on higher yields. Fed officials see the steepening from last year’s extremely low levels as positive indications of confidence in the recovery and perhaps even, dare they imagine, faith in the Fed’s new reaction function.
The March SEPs and Rate Dot Plot
Indeed, if true to the new reaction function, it means that even though real growth this year and next is certain to be marked up, and unemployment down, in the Summary of Economic Projections and rate plots for the March 16-17 FOMC meeting, the rate projections are more likely than not to remain little changed. Instead, the higher growth and progression towards maximum employment will first show up in a higher number of FOMC member projections for an inflation overshoot in 2023, with perhaps a few penciling in a 2022 overshoot.
The March rate projections, in that sense, may prove to be a critical test of the Fed’s current messaging offensive. If more than a scattering of FOMC members do mark in a sooner or steeper rate trajectory as their assumed appropriate policy path across the three year forecasting horizon, it could quickly undermine the credibility of the Fed’s new reaction function and show up in more volatile and higher rates out to two years. It would also mean the wider FOMC consensus on the new framework was not especially deep.
That is, in turn, putting an added premium on the near term messaging priority to keep a lid on an inflation scare and anxious fears of an overheating economy. A newfound messaging discipline was already on display in an unusually one-sided weighting to the January meeting Minutes: it seemed every possible takeaway that might offer a glean of optimism on the outlook was quickly tempered with a “however” or “that said” before being downplayed and juxtaposed against more somber outcomes; indeed, there was barely a mention at all of any upside risks to the outlook, with “most” of the FOMC participants still viewing the risks as “weighted to the downside.”
The strong consensus view was especially apparent in the almost adamant assertions about “temporary” or “one time” price spikes in the Minutes that will invariably be repeated in the testimony and remarks this week. The plunge in the price pressures last spring will begin to fall out of the data later, lending to an expected pop in measured inflation by May. On that, there is a uniform consensus across the Committee.
The Debate over Inflation Dynamics
But there are distinct pockets of dissenting views within the Fed system over the degree of inflation risk, and who can say for sure what consumers will do with their massive pile of forced savings? There is almost certainly an upside risk to growth assumptions and in turn what it might mean for inflation dynamics.
And while even the most hard-core inflation hawks of old tend to share the skepticism of any near-term sustainable inflation risk, they remain more cautious in betting on price pressures ebbing amid a surging fiscal stimulus stoking aggregate demand, potential supply disruptions here and there, and of course abundant liquidity courtesy of the Fed’s highly accommodative policy stance. All the ingredients needed for a sustained rise in inflation are already baked in the cake, with the impact on consumer inflation expectations being the big unknown.
But that, however, is likely to remain a minority view and kept to the margins of the main policy messaging this week and right through to the March meeting: the dominant Committee majority remains skeptical inflation could rise enough for long enough and broadly enough to become embedded into higher inflation expectations and make its way into a stronger momentum in underlying inflation.
If anything, keeping the monetary taps open and looking through the initial, and probably temporary, pop in inflation rather than being baited into a premature reaction is kind of the point to the current reaction function. The bet, even if core PCE is nudged higher this year, is that the median for 2021 is probably going to end up no higher than 1.80%.
And rather than dialing back to how the ‘high pressure” ambitions of the New Economics in the 1960s led to the Great Inflation of the 1970s, some Fed officials point to the behavior of inflation in 2017 in the wake of the tax cuts and spending stimulus of the Bipartisan Budget Agreement when the economy was already running above trend: after rising as initially expected, price pressures began to fade, albeit with the last round of rate increases and the trade wars adding to the downward pressures.
More to the point for the coming weeks, there is a view that any wobble to cede ground on a more elevated inflation risk – after nearly ten year of undershooting the 2% inflation target — would put the entire thrust of the new framework at risk. So even if the base case for a very gradual rise in inflation over the next several years on the back of running a high-pressure economy proves to be wrong, a Committee majority has concluded they have to stick to the patience script through the coming months.
The Financial Stability Issue
The inflation risk where the Committee consensus runs thinner – and where Chairman Powell should expect to be grilled in his testimonies, is on asset price inflation and whether the Fed’s highly accommodative policy stance is allegedly fueling asset bubbles. The repeated assertions in the Minutes attributing higher equity valuations or narrowed credit spreads solely to investor optimism in the recovery without acknowledging the role of the Fed’s liquidity had a distinct defensive feel to it and, frankly, was hardly credible.
Chairman Powell and other Committee members will no doubt squirm somewhat under the questioning, and the strongly worded section on financial stability in both the staff briefing in the January meeting and in a harshly toned stand-alone box in the monetary report to Congress on financial stability risks will make it hard to glide over the issue without a bit more detail to counter the anxieties over asset prices.
The needle to be threaded in the near term on the financial stability front will be in pressing the case that the eventual policy response will not be through changes in balance sheet policy, at least not any time soon, and it certainly won’t be through rates, but rather in a coordinated macro prudential policy with the US Treasury and through FSOC to strengthen non-bank resilience.
On that, we will be keeping an eye on the remarks by Vice Chairman Randal Quarles on Thursday, who is speaking on the bank stress tests, but which may include a progress report on policy initiatives launched in the wake of the March 2020 treasury market dislocations. We would also note the next bi-annual Financial Stability Report is due in May, by which time Treasury and the other FSOC agencies should be more fully staffed up and moving forward with new policy initiatives, particularly with proposals for capital and liquidity safeguards aimed at bolstering the resilience of the non-bank sector.
Guidance by St Augustine
The Powell-led policy messaging paradigm will no doubt be put to the test in coming weeks with every new data point that points to a stronger than expected rebound or asset prices that keep soaring upward to even loftier valuations. But we seriously doubt Chairman Powell will be distracted in the near to medium term from providing support to the lead of fiscal policy in driving a broad-based, inclusive recovery (see SGH 2/9/21, “Fed: Eyes on the Prize;” SGH 1/8/21, “Fed: Until the Economy Says No,” and SGH 12/1/20, “Fed: The Yellen-Powell Nexus”).
So in that gray zone between the market’s quickness to price, prematurely in the Fed’s eyes, and the actual confirmation of data on higher sustained inflation that triggers a lagged policy response, we still expect Fed officials to stick to the script if there is to be any chance of convincing the market and the public to accept a higher inflation in an economy that is allowed to run hotter, for longer. Like St. Augustine’s vows of chastity, the time to fret over inflation risk is for later, not now.