Fed: The December Fallback

Published on September 13, 2016

Key Takeaways:

While a move this month still cannot be ruled out, we now think, on balance, the Federal Reserve is more likely than not to raise rates a second time in its path of policy normalization in December rather than September.

Neither the Brainard speech nor market pricing, or election uncertainties, are major factors in a close call September decision, but rather the value in December’s long runway to message rate intentions and data that confirms the forecast will prove decisive.

The September messaging will be crucial in conveying a “hawkish hold” to underscore the FOMC’s commitment to policy normalization and the firm consensus to raise rates before year-end, while the rate dot plot will likely convey an even more gradual path beyond this year.

September 13, 2016

There has certainly been no shortage of contrasting something-for-everyone speeches and public remarks by various members of the Federal Open Market Committee in recent days to frustrate a market that craves certainty.

But when Chair Janet Yellen begins this week her customary round of conversations with her Committee colleagues to assess their views and concerns and where the consensus can be shaped in the pivotal September 20-21 FOMC meeting, our sense is that there is more of a slowly building consensus than headlines would suggest.

*** The FOMC consensus to raise rates a second time in the policy normalization path before year-end, essentially in place since summer, is still quite solid. The data has for the most part stayed on track with the forecast, setting the stage for that “serious discussion” on whether to raise rates as soon as the September meeting. For that reason, a September rate move still cannot be ruled out. ***

*** But we think, on balance, and while conceding it will be a close call, the Committee consensus is moving towards a December rate move over September. It is likewise a sentiment we suspect will be shared by the Chair herself, who tends to prefer a careful, cautious approach in laying the groundwork to a rate move and to building a solid consensus, ideally without dissents on each rate hike. ***

*** Neither a last minute dovish speech nor the market’s low probabilities pricing, or even the wild uncertainties in the US elections, are likely to be major factors in that decision. Rather, the value in data confirming the forecast and a long messaging runway are the decisive drivers to the likely September “hawkish hold” pointing to December, while the rate dot plot will ideally convey a gradual and shallow rate path beyond this year. ***

Brainard’s Contours

Perhaps the most important thing to keep in mind when weighing what to take away from the cross current of seemingly contradictory views expressed by members of the Federal Open Market Committee in recent days is that they are as much lobbying their colleagues as they are conveying any unified policy message for the public and the markets.

And that was certainly the case in Governor Lael Brainard’s adroitly timed, last before the black-out speech Monday afternoon, in which she doubled down on a dovish case for “prudence” on near rate policy in describing the “contours of today’s economy.” Her true to form speech also stomped on the somewhat rash rumor late last week that she might go hawkish, which was more than a little unlikely (SGH 9/8/16, “Fed: Brainard”).

Her reminder of the risk management concerns when so near the Zero Lower Bound and the absence of near inflation risk were the strongest points, and they are shared by a majority of their Committee colleagues. But at the same time many of her arguments had a certain sell-by date feel to them (i.e. possible problems in China or the emerging markets or wherever, evoking “the dog in outer Mongolia” search for impossible risk-free conditions for a rate decision) that seemed to explain the caution up to now rather than presenting a forward looking case to delay a rate hike still further.

At the end of the day, Brainard was not arguing for no hike ever, and our sense is that her arguments did not necessarily go against the case for a hike by year-end, nor will they prove particularly persuasive in the September meeting. But where her speech obviously did have considerable influence was in crushing the market pricing for a September move, which by our last look, is down to under 25% if only looking at the fed funds futures.

Fed officials will strenuously deny the market pricing dictates the Fed rate policy decisions or its timing, and if the FOMC truly felt there was a pressing need to lift rates, there is little doubt they would not hesitate, and indeed, there are some arguments still being made around the table an against-expectations rate hike would boost the Fed’s own credibility and crack the market’s excessive complacency.

But that said, if there is in fact no sense within the Committee of near inflation risk or indeed a particularly pressing need to raise rates — in what is, after all, expected to be a very gradual rate tightening trajectory stretching out for years — it would in fact be imprudent to ignore very low pricing probabilities going into a policy meeting.

The Lean to December

There has been, we think, a fairly strong consensus for a second rate hike in the policy normalization strategy since the summer (SGH 5/17/16, “Fed: June Messaging”), which in the end was delayed but not derailed by the outlier Non-Farm Payroll print and the downside risk in the shock Brexit vote. And the data since then have more or less stayed on track with the forecast for a steadily tightening labor market and an eventual rise in inflation.

So under those circumstances, absent a new shock somewhere, anywhere, to deter a rate hike, it is fair to ask if not now, when, on the elusive second rate hike, and for that reason alone, we simply cannot rule out a rate hike next week in what will invariably be a close call decision.

But, on balance, we now believe the balance of the policy decision coming out of the Committee discussions next week will lean to December over September, and for a “hawkish hold” messaging pointing to the high probabilities for a move before year-end and to prepare the long runway to another December rate take-off to bring the markets (and other central banks) fully on board to ensure a minimum of dislocation.

Probably the most important component to the pass on September to look at December will be the value in the data confirming what is for now high expectations in the forecast for a pick up in growth to a pace at or just above an annualized 2%, and with this above trend growth still steadily tightening labor market and an inflation still “conforming” to the forecast to be slowly rising to its 2% (symmetrical) target.

The data in this data-dependent path, in other words, does not have to strengthen, but only to continue its steady, albeit just this side of tepid, pace of growth to cement the consensus to hike in December.

That, in turn will enable the Chair to shape a solid consensus for the second rate hike and probably without dissents. And while dissents are not necessarily a bad thing in reinforcing the intended messaging, it would appear Yellen puts a high value in a unified Committee without dissents when the Fed undertakes a next step in a rate hike.

That, of course, does mean an even higher importance in the policy messaging Chair Yellen must convey in her post-meeting press conference, above all a “hawkish hold” messaging that, all else being equal, indicates the probabilities are quite high for that elusive rate hike before year-end.

At the same time, the often problematic rate dot plots unveiled in September are likely to show a further downward drift in the estimates of the longer run neutral, and in the pace of the rate hikes beyond this year. That should likewise lend support to the very gradual and shallow rate tightening trajectory the Fed is messaging.

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