As they head into their end-of-year meeting next week. Federal Open Market Committee members have a clearer sense of what they are likely to do in moving towards “policy normalization” than they are about how and when to best phrase their forward guidance to align market expectations to that policy path.
*** Whether the FOMC can take a considerable time before moving on rates or will be patient in removing accommodation, our sense is of a gathering momentum behind the Committee consensus for a rates lift-off next June, with almost no chance of a move before then and a fairly high bar to a delay beyond September. This assumes, of course, the incoming data doesn’t deviate too far from the central tendency path, but this narrow window for lift-off is being driven as much by a growing understanding of the inertial nature of inflation and the need for a long very gradual rate tightening cycle as much as by any sense of an accelerating recovery. ***
*** Indeed, not all that much has changed in the outlook since October that would move the needle on the forecasts or the policy stance. Next year’s growth may be tweaked up modestly in the December meeting projections, while unemployment may be marked lower through the year, and its longer run levels slightly lower as well in the forecast assumptions. Inflation is likely to be adjusted down slightly under the downward push of lower oil prices but whose upward climb will be reaffirmed in the later years of the projections. The economy, while with clear momentum going into next year, is reaching a “normal” growth rate rather than accelerating. ***
*** Guidance changes next week will mostly be a tactical decision, but it will essentially boil down to whether a Committee majority is comfortable in sending a more hawkish signal on rates just yet and so far from June. Our sense is that a sizable number of Committee members going into the meeting are not, but dropping the “considerable time” for some form of the “patience” formulation already previewed in numerous speeches could come as a “technical” updating of sorts to an aging, backward-looking guidance for a more forward-looking data defined framework. At minimum, Chair Janet Yellen can be expected to message a more flexible meaning to the new patience language, whether introduced in the December statement or indeed as late as next March. ***
The Impact of “Inertial Inflation”
The narrowing window for a first rate hike is being shaped less by how healthy the growth and job gains are looking, but ironically, by how low inflation is; more specifically, it is the growing sense across the Fed system that the current persistence in low inflation, which should have been by all accounts outright deflation in light of the enormous output gap and labor market slack, may later in the business cycle be just as persistent, only in this case resistant to a policy tightening once the upward price pressures are finally underway.
Indeed, we think this inertial nature of the inflation dynamic is having an underappreciated impact on the Committee’s rate assumptions and the current policy path taking shape. And perhaps, if reversed back into the discussions next week, it might provide some context to the calculations going into the potential changes to the forward policy guidance.
The effects of what could be described as an “inertial inflation risk” is twofold. First it is making most Committee members a bit more reluctant to tolerate an overshoot of the 2% inflation target by much or for very long. This may incidentally torpedo the efforts by Minneapolis President Narayana Kocherlakota to make changes to the Fed’s annual statement of longer run strategy and monetary policy to reflect the symmetry to the target and to confirm the willingness — some would say the need — to push inflation above its 2% medium target to ensure maximum demand and full employment.
A probable majority of the FOMC have in fact been perfectly willing to risk an overshoot of the target during the years of the optimal control policy path when the output gap and labor slack were so clearly large. But as the Fed gets closer to achieving its twin mandates for unemployment and inflation, this perceived “inertial risk” in the inflation dynamic means the more asymmetrical to the upside target the FOMC is likely to get.
Secondly, and of more immediate concern, is that this sense of an inertial inflation dynamic looks to be deepening the consensus for both a longer, slower rate tightening cycle than anything in the past — assuming the market pricing does not force excessively radical adjustments in the trajectory as New York Fed President Bill Dudley has forewarned — and for a start to the rate tightening by the “mid 2015” lift-off being telegraphed by more and more Committee members.
This longer, more gradual tightening cycle is built around a bracketing of the unemployment and inflation mandates being fulfilled sometime in 2016 with a rates lift-off one year before in 2015 and reaching a neutral or equilibrium interest rate one year after, or sometime in 2017 (see SGH 11/7/14, “Fed: A Gathering Confidence”).
That stands in stark contrast to the more traditional rate tightening cycle under Taylor Rule assumptions that would have seen a first rate hike this year and reaching a neutral level long before unemployment reached anywhere near assumed longer run levels. So in that sense, the Fed’s current policy path laid out under former Chairman Ben Bernanke and current Fed Chair Yellen has indeed been a highly accommodative path and by all accounts, quite unprecedented.
But it is, in effect, how the Fed is countering a potential secular stagnation from becoming a permanent feature of the US economic landscape. Almost by definition, a central bank can never accept secular stagnation in its fullest form as fate, and so despite the absence of any near term inflation risk, this “early” start to an unusually long and gradual rate hike tightening cycle could perhaps be best described as the second phase of the long path back to policy normalization after a first few years of unconventional policy trial and error at the zero lower bound.
A Forecast Intersection with June
There is also an underlying countervailing impulse in the current forecasts against a first rate increase before June. Most of the recent data releases such as the JOLTs report earlier this week or last Friday’s Nonfarm Payroll do not necessarily move the needle on the forecasts or on the overall policy stance as much as it bolsters the level of confidence around the existing growth projections and the steadily improving labor market. The economy is slowly moving from disappointing to just normal, but nothing to warrant a rushed response on either policy or guidance.
Along those lines, we expect the projections for real growth in the December unveiling of the Summary of Economic Projections will show an uptick of a point or two in the 2015 narrow CTF range, with a similar downtick in the inflation projections. The SEPs will also almost have to reflect a faster pace in a declining unemployment rate pushing deeper towards the bottom end of the Fed’s assumed 5.2%-5.5% longer run non-inflationary rate — and which may in fact also see more Committee members joining their more dovish colleagues in marking the longer run rate down toward 5%.
And interestingly, if there is any change in the core cluster of the SEP blue dot rate plots for 2015, they are more likely to be marked down, not up, despite the better looking growth and unemployment numbers, but simply because many Committee members have more confidence in the forecast for a steady and sustained looking recovery.
The current data, in other words, even with the recent spike in the numbers still doesn’t point to a rate increase next spring. Doing so in fact could heighten the risks of a premature tightening in conditions that could derail the recovery just when the labor market may be reaching into its last stages of full employment with better wage growth.
It leaves June as the earliest and most likely time to begin the lift-off in rates. And on the other hand, under the long gradual tightening scenario, delaying a first rate hike beyond, say September next year, could risk an excessive overshoot of the 2% inflation target at the back end of the long cycle or force such a rapid series of rate increases it would put the extended recovery at risk and potentially push rates back to the zero lower bound in the next recession.
Thus in the calculations of many staff and FOMC members, the intersection of these considerations points neatly to a June rate hike, with some leeway to waiting until September, assuming as always the unfolding data cooperates nicely with current projections.
Indeed, our sense is that this evolving reading into the inflation dynamics and the merits of the longer, slower tightening cycle is a major factor pulling even the more dovish FOMC members to a June rate hike, in part because the risk of damage in a premature tightening when inflation may still be so low is mitigated by how gradual the rate cycle is likely to be.
It is also a key reason why low inflation in itself will not preclude a rate hike (see SGH 10/3/14, “Fed: A “Patient” Reaction Function”) or push the first rate hike into late 2015 or 2016 as some Street analysts are still expecting.
The Signaling Challenge
How this will sway the debate over what to do with the current forward guidance next week is not obvious, since there is no apparent consensus one way or another on the question going into the December meeting.
The Committee seems to want most to do with the forward guidance is to update it in almost a technical sense without much of a change in the policy signal per se; more descriptive language to better capture the nuance in the Committee changing views, giving more context to the rate tightening trajectory, minimizing potential market dislocations but maximizing policy flexibility. At minimum, the FOMC will probably nix the backward-looking link to the end of the bond purchases for a more forward looking guidepost, perhaps something like inflation and unemployment moving towards mandate-consistent levels.
There are plenty of arguments for dropping the loaded but aging “considerable time” language from the guidance, since on its surface, its embedded six month to a first rate hike connotations of the “considerable time language would seem to fit neatly into the base case for a June lift-off, in an echo of the 2004 template. And in a sense, “bridging guidance” like some form of the wording the Fed will be “patient in removing monetary accommodation” is in no small way akin to tapering QE rather than the prior cold turkey end to QE.
And shifting to the patience language does offer more flexibility, and the option of a rate hike earlier than six months. That in the end was a key factor to the decision for a change in the guidance language from a “considerable period” to “patience” in January 2004.
But this December, that option is not necessarily needed because the Fed sees little chance rates will be raised in the spring. More to the point, it still feels to us that the path of least resistance for many Committee members going into the meeting is to keep the well-worn “considerable time” phrasing in the statement until they are more comfortable signaling a rate increase is indeed nearing, whatever its replacement language is. They know that once removed, the market countdown to a rate hike will begin and the six months to June could prove to be a long time.
And in light of the fact the clear signaling for a rate hike could prove nearly as potent as the actual hike, it may pay to split the difference in the countdown to a rates lift-off to three months from six months. Pushing back the key rate signal would allow for more time to assess the data for even the slimmest of evidence that inflation is indeed turning up or that higher wages are finally looking more sustained than a single month, a reaffirmation if you will, that the forecast assumptions can indeed be trusted.
The compromise trade-off would be a more compressed countdown and using the first half of the year to well message in post-meeting pressers, meeting Minutes, and speeches the patience language to mean a rate increase looms within a few meetings.
There is, of course, no good time to make such an adjustment in guidance language, and there is a strong sentiment to clean up the statement overall and the December guidance could end up somewhat subsumed in the broader recommendations to revamp the communications policy by Vice Chair Stan Fischer’s subcommittee.
But whatever the Committee opts to do with its forward guidance next week, a June lift-off in the first rate increase in a decade and an unprecedented long tightening cycle remains likely. It just may be bumpier in getting there.