Fed: Suspended Disbelief

Published on June 13, 2017

The Federal Open Market Committee’s likely June meeting policy announcements this Wednesday have been so thoroughly telegraphed that market expectations are well set. But beyond June, this week’s meeting may well be the last this year amid relatively calm market and political conditions.

*** The FOMC is still highly likely to raise the policy rate to a 1%-1.25% target range tomorrow though it will no doubt be debated far more than it would have been just a week or two ago. On the balance sheet, with the FOMC’s unexpectedly rapid progress since the turn of the year, there is no reason not to expect an unveiling of the promised “augment” to the Exit Principles and Plans at this meeting, or if a consensus comes up just short, by the July meeting. ***

*** The Committee will look through the recent weakness in inflation to stay the course on policy normalization, but an influential minority will seize on the sharp drop in inflation expectations yesterday to argue the Fed risks the falling inflation expectations becoming increasing entrenched with further rate hikes. Unless the data and surveys reverse in the coming months, we think a September rate hike is unlikely (see SGH 5/22/17, “Fed: A September Pause”). ***

The Statement and the SEPs

** The June meeting statement language will acknowledge the modest softening in the labor market and perhaps the slight slowing in the pace of economic activity, but framed against likely continued above trend growth. More importantly, the inflation language will have to affirm the recent dip in the inflation data and expectations while still reaffirming its transitory nature and staying the course on policy normalization. We do not expect any sort of forward guidance language to steer expectations on rates in the second half of the year.

** The Summary of Economic Projections are likely to put the Fed’s dilemma with its twin mandate into sharp relief with the diverging movements in the inflation and unemployment forecasts. While the June median projections for unemployment should drift down to perhaps 4.3% or less by year-end, from the 4.5% in March, the median on inflation is likely to soften to perhaps 1.8% or less from March’s 1.9%. And there may be an even wider dispersion on both inflation and unemployment in the full range of Committee projections before they are topped and tailed for the central tendency forecast.

** The Committee estimates for the longer run unemployment level was apparently marked down slightly at the May meeting, but on balance, we do not expect a dovish decline in the median for the longer run unemployment estimates in the June SEPs. For the most part, most of the Committee believe NAIRU is impossible to know with any point-certainty and still believe their current 4.5% median is about right as a midpoint. More to the point, there is a prevailing sense the unemployment rate needs to run below NAIRU for a while before it pressures wages higher.

** The June rate dot plot may not be the wild card it can often be relative to the intended policy messaging. While there is likely to be some downward drift in the rate hike projections for 2017, for instance, we doubt the median of three rate hikes will slip to two, meaning one more rate hike will still be the base case in the second half of the year. With so much political uncertainty looming and a turnover in the Board of Governors and some districts destined for next year, the rate projections for 2018 and beyond should be taken with a huge grain of salt.

** The contours of the revised Exit Principles and Plans for the balance sheet seems likely to be unveiled on Wednesday, though a delay to July can’t be ruled out if the final consensus falls short this week. It will almost certainly be too early to go into the detail on the expected caps and pre-sets to the “smaller and sooner” start to balance sheet reduction. We do not expect any pushback from Chair Yellen on expectations for the initial run-off of maturing assets by the fourth quarter of this year, though she will no doubt warn of the dangers to the timeline if Capitol Hill delays an increase in the federal debt ceiling.

Yellen’s Presser as Main Event

** Chair Janet Yellen’s post-meeting press conference is likely to be the main event. She can be expected to assert the Fed’s base case outlook for continued, just above trend growth, and the steady tightening in the labor market that underpins the Fed’s somewhat strained assumptions on slowly rising inflation. She will likewise do her best to keep the FOMC’s options open about the rate outlook in the second half of the year, perhaps stressing summer data and especially the inflation expectation surveys doing most of the heavy lifting in guiding the policy messaging going into the fall.

** She is also likely to affirm that while the FOMC is committed to a symmetrical inflation target, once an inertial inflation is underway, it could prove difficult to slow without overstepping on rate hikes and triggering a recession. On balance, the safer recourse will be to stick to slowly lifting the policy rate towards a neutral level, assuming the data stays on track with the forecast. If the FOMC has to choose between a still tightening labor markets versus near term inflation softness, all else being equal, they will tend to put greater weight on the former over the latter, and for a continuation of policy normalization.

** But there is no question there will be a more cautious, somewhat softer tone to Chair Yellen’s remarks. That will especially be the case if she is asked about the rates outlook in the second half of the year, when the ongoing political dysfunction, persistence in low inflation, and the Fed’s watchful eye on inflation expectations will be conspiring to make the policy outlook much more uncertain in the second half of the year than the first half. Indeed, to maximize the FOMC’s policy flexibility amid elevated risks going into the fall was one of the more powerful arguments for the March and expected June rate hikes.

** In particular, even if Yellen seeks to stress the Fed’s still firm belief the recent dip in the hard inflation numbers will prove transitory, we do think she will not underplay the concerns she shares with other Committee members in watching for any evidence of sustained declines in inflation expectations, which the Committee’s hawks and doves alike increasingly see as a primary indicator of future inflation (see SGH 6/5/17, “Fed: Inflation and the Near Outlook”). So it will be a careful scrutiny of the inflation surveys and market measures over the coming months, and a likely driver of Fed messaging going into September.

** And finally, Chair Yellen will almost certainly get a question about the easier financial conditions since the Fed’s quickened pace of rate hikes began in December and how it may influence the pace of rate hikes going forward. Monetary policy operates with a lag, Chair Yellen may note, and the flattening in the curve may have little to do with monetary policy per se than it may with other factors, like the temporary effects of a fading Trump reflation trade. But for now, our sense is that an FOMC majority is not all that bothered by the easier financial conditions, and will only become more focused on the issue when the policy rate is nudged up closer to neutral.

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