It should have been no surprise to anyone looking at a Bloomberg screen this week that various Federal Reserve officials were adopting a more dovish tone in their remarks these last few days. Data that is mixed at best, persistently low inflation, policy uncertainty abroad, and highly volatile, downward-lurching markets will do that to you.
*** But we would not take that dovish shift in the Fed messaging too far, at least not yet. While a March meeting rate hike has, as we had been expecting, essentially been pushed off the table for now, and Fed officials are getting a bit more anxious about the economic outlook, they are at present making but tactical adjustments to be better positioned by perhaps the June meeting if policy should indeed need to pivot back on a more distinct easing path. Their immediate concern is to calm the market’s gloom over the outlook that threatens to become self-fulfilling, and on that front, tomorrow’s Non-Farm Payroll print could present some communication challenges. ***
*** While the Federal Open Market Committee is not especially wedded to the base case of four rates hikes this year, and will patiently wait it out at three or even two rate hikes as inflation conditions permit this year, a solid Committee majority remains firmly committed to the upward rates strategy of “policy normalization” and to a slack-based Phillips Curve policy framework. Indeed, the whole point of the “sooner and slower” rate path was to ensure maximum policy flexibility to provide the time for the market to adjust its positions and for the Fed to closely watch for downside risks to the outlook. ***
*** Two points were also made earlier this week by Fed officials that we believe underscore the longer term dovish lean of the Fed’s policy path, and which are likely to be picked up as themes through the year. The first was the affirmation of the Fed’s willingness to overshoot its mandates for employment and inflation, and the other the benefits in a large balance sheet with the accommodative support of reinvesting to maintain a constant duration in the portfolio. It is our sense the door is also being opened to both a more activist balance sheet management if needed to temper excess tightening and to negative rates as policy options if the outlook turns south. ***
Turning Market Sentiment
The dovish-leaning comments through this week by Vice Chairman Stan Fischer, New York Fed President Bill Dudley, and Board Governor Lael Brainard — Kansas City’s Esther George opted to hold to her hawkish line — were certainly meant to convey the Fed’s policy flexibility and a modest tilt against the likelihood of a March meeting rate hike: if the economy slows, so do those rate hikes.
But in doing so, the comments were also meant to throttle back some of the market’s gathering gloom over the prospect of a “policy error” in December’s rate hike that would be compounded with four more rate hikes this year. Indeed, the Fed’s more immediate concern is that the financial markets tightening underway, driven more by anxieties over what may be coming rather than what has, could become self-fulfilling.
So by dialing back the messaging on rates, strongly hinting that a March rate hike is probably off the table, the thinking is that they can buy some time to calm the markets down until there is a clearer picture on the outlook. If tightening financial conditions “were to remain in place by the time we get to the March meeting we would have to take that into consideration,” Dudley told a reporter this week, “but it’s a little soon to draw any firm conclusions from what we’ve seen.”
But what he and the others were essentially saying this week was that December’s base case of four rate hikes this year was just that, a base case, and not even the more hawkish FOMC members will lose any sleep over a pass on March if the data softens (see SGH 1/27/16, “Fed: A Dovish Lean”). A likely pass on March would still be but a tactical adjustments within a (so far) unchanged strategy to “normalize” policy over the course of a very gradually rising rate trajectory expected to go on for years.
And to pass again on an April rate hike is likewise no major event — it would be awkward to hike at a non- presser meeting regardless of how much they insist every meeting is live — and it is our sense that only come the June meeting will the FOMC face a moment of truth on whether its assumptions on the economy and especially the evolution of inflation remains intact.
In passing on a September rate hike last year, for instance, the Fed sought to fine tune its messaging to better prepare the markets, and to be sure no damage to the outlook loomed just over the horizon, before proceeding to hike in December. In a similar fashion, if the domestic drivers to growth prove to more than offset the ill-winds from abroad as the Fed is still forecasting, then the Fed will press ahead with that second rate hike in due course. The persistence in low inflation, and the extended run of a strong dollar, is of course making that all rather problematic.
But then, that was the point to the “sooner and slower” policy path first mapped out by Chair Janet Yellen some time ago, to have the luxury of stepping back on the pace of removing monetary accommodation when necessary to allow the market to adjust and to assess just how close the Fed is keeping to a slowly rising effective equilibrium real interest rate. For now, a tactical retreat may be in the making, but it is hardly the concession of “policy error” to pass on a March rate hike.
Of course, if the job creation engine does indeed look to be stalling by spring, then all bets are off. The case for “policy normalization,” however gradual it is intended, and for that faithfully anticipated rise in inflation, both fall by the wayside.
And against that backdrop, tomorrow’s Non-Farm Payroll number may present the Fed with something of a communications dilemma. The Fed built into its projections for this year a somewhat slower average pace of job creation, perhaps falling to as low as 160,000 or so jobs a month. On their calculations, in light of such a low trend growth potential, that should be still enough to further mop up the slack around the outer edges of the labor market in bringing the discouraged and long-term unemployed back into the labor force.
Even taking into account the now delayed base effects of the “transitory” strong dollar and weak oil prices dropping out of the data, that is still believed to be enough labor market tightening to generate a fair degree of upward wage pressures on services prices, perhaps now towards year-end. And that, in turn, was what drove the “sooner and slower” policy path that began with December’s watershed first rate hike since 2006.
But set against the current market pessimism, any jobs number below the market expectations around the 200,000 mark could further reinforce market pessimism on the outlook — especially on the back of Wednesday’s disappointing non-manufacturing ISM. For the Fed, that sort of print, or even another next month, will not in itself be enough to push them off the current policy path, but more than anything else, the Fed fears the gloomy takeaway from a lackluster jobs print could become self-fulfilling by further undercutting consumer and business confidence at a critical juncture.
That Fed officials passed on the chance to frame their own expectations in front of tomorrow will leave them vulnerable to however the market opts to interpret the jobs number.
The Willingness to Overshoot the Mandates
Perhaps in that context it is interesting to highlight the dovish undertone in the two themes Vice Chair Fischer made a point of stressing in his remarks on Monday, which was by far the more important of the Fed speak this week.
The first was his affirmation that the Fed is wholly willing (and probably needing) to overshoot both its inflation and employment mandates. It may not mean much in the near term, but a bit further down the road, it is a powerful signal about just how patient and gradual the rate policy path is going to be, and how far the Fed is willing to push policy, which may at least in the near term if taken in by the markets, help to stem the decline in inflation expectations.
Only a persistence in the headline unemployment falling ever deeper below its assumed longer run levels would reverse that willingness to overshoot the mandate, as the pay-off in overshooting is twofold in both mopping up the slack that the Fed believes lurks in the outer layers of the labor market beyond the headline unemployment rate, and above all, in helping create upward pressures on core inflation to ensure mandate-consistent levels on that front…a policy two-fer.
And indeed, Fischer — who leaned hawkish in the run up to the December first rate hike — also made a point to draw attention to what we think was a significant change in the annual “Statement on Longer-Run Goals and Monetary Policy Strategy” to formally affirm the 2% inflation target was not a ceiling, but was symmetric (see again SGH 1/27/16, “Fed: A Dovish Lean”).
While Fed officials have said often enough that such an overshoot was always possible, to make it so explicit and in the formality of the rarely tweaked annual statement of policy strategy underscores just how patient the Fed is likely to be in raising rates as gradually as necessary.
That may not mean much in the near term, but we do think it will especially enter into the policy calculations further down the road, and at minimum give the more dovish Federal Open Market Committee members extra ammunition to make their case. Indeed, it is our sense that is the price the doves exacted in moving forward on a first rate hike in December without dissent, rather than what was probably their more preferred start to policy normalization in, say, June this year.
And on the Balance Sheet Option
Fischer also made a point of bringing up the issue of how to “integrate” the balance sheet with rates policy. There is a “benefit to maintaining a larger balance sheet for a time,” he noted, namely that it allows the Fed time to first focus on normalizing rates as their primary policy tool, and perhaps to create some rate cushion in case the economy turns south.
But while he did not offer much in the way of any further details, there is another benefit to the large balance sheet that we believe could be further fleshed out later in the year by Fed officials. One reason Fed officials can say with confidence that monetary policy remains accommodative is that, unlike last year when there was hardly any maturing treasuries, there are buckets of treasuries rolling off the portfolio this year that are being re-invested at their original maturity.
That means while they are slowly raising rates — normalizing rates — there is at least a steady accommodative support in maintaining the existing duration in the portfolio. But it would not take much in operational terms to boost the duration effects of the portfolio by perhaps adding some sales at the shorter end of the portfolio and buying longer term treasuries again in a repeat version of 2011’s Twist operations.
We suspect this point may rise to the forefront of the Fed messaging as the first line of defense to counter any drift to a stall speed in the recovery, much less the notion of recession rippling through the market sentiments at present. And that would especially be the case if Treasury added the weight in its debt management policies by issuing more at the shorter end and reducing longer term supply.
That, in any case, would come long before the Fed seriously weighs the option of negative interest rates, which Fischer, along with a handful of other Fed officials, has theoretically now opened the door ever so slightly to, however unlikely the Fed may think they might be needed.