The most immediate takeaway from the Federal Reserve Open Market Committee decision and presentations today was without doubt the dramatic marking down of the Summary of Economic Projections blue dot rate plot across all three years of the forecasting horizon.
The sharp drop in the 2015 rate dots stood out and, in particular, five rates dots are now down to just a single rate hike by year-end, while two “dotters” remained firmly in the 2016 column.
But we would caution against an overly dovish reading of the dot changes. A couple of points we think are important to make:
*** First, the more important message of the 2015 dots, we think, was the remarkable compression of the dots, a visual clue to where the Committee consensus is likely to converge, with all but two of 17 FOMC members now penciling in at least one hike and no more than three hikes before year-end. It is not so much that the rate outlook is becoming more “dovish,” though of course it is, but that the rate hikes this year are more certain. ***
*** And second, if this convergence of the rate hikes is set against the central tendency forecast of an economy that, as noted in today’s statement, is “expanding moderately” with jobs growth continuing to “pick up” and further tightening up labor market slack, we still think that by the end of this summer the Fed’s much touted “data-dependent” policy path will lead to a Committee consensus for a first rate hike in September (SGH 6/12/15, “Fed: A Step Closer”). ***
The Two Dot Debate
The new dot matrix for 2015 does admittedly provide the grounds for thinking the Fed may want to delay a first rate hike until December. But we put less weight on that probability, at least in part because we suspect the Fed will be loath to launch a first rate hike in eleven years and after six years plus at the zero lower bound in a highly illiquid December.
But we likewise think the Fed would be able to undertake a second rate hike that is already clear of the possible dislocations if it sees the need. Along those lines, we in fact doubt the five marking their rate dots down a single rate hike in the remaining six months of this year are shying away from a September first rate hike as much as they are taking a more cautious assumption of prudence in a second rate hike as soon as December.
Perhaps the large point is that, assuming a first rate hike in September, a good chunk of the Committee want to maintain some optionality on the timing to that second rate hike; after all, they have all been preaching the data-dependent rate path, so we guess we better take them at their word.
And while we would lean to December for a second rate hike, and thus a likely convergence in the Committee consensus to the “two rate hike dotters,” it is also worth noting that for the Fed, there is not all that much difference in the larger scheme of things between a second rate hike in December or a bit later in January, however much it means to the markets trying to price the odds to the second hike timing.
Gradual and Shallow, Right?
Indeed, the main takeaway from the dot chart across all three years of the forecasting horizon is probably just how gradual and shallow the approaching rate tightening cycle is going to be, as Chair Yellen stressed in what seemed like a gazillion times in her press conference (and therefore don’t overreact by excessively pricing in higher yields to a first rate hike was her less than subliminal subtext).
The tweaks to the SEP projections echoed the same message, in that there seemed to be a modest shift in the Fed’s assumptions. For instance, the annualized growth this year had to be marked down, by default obviously, since the first quarter was so lousy, but it seems to be expected that it will still be above trend growth and therefore good enough to continue tightening labor market slack in its broader measures.
That is, while the headline unemployment may slow or move more sideways from here, it is mostly for good reasons, in that the labor participation rate is cyclically edging up a bit more, or perhaps because productivity, as Yellen suggested today, is picking up a bit sooner than expected. Either way, it means whenever they undertake that first rate hike, as Yellen noted, the subsequent path either can be, or needs to be, unprecedentedly long and gradual, shallower than any in the past.
We also thought it was noteworthy that Chair Yellen made something of the case for a “sooner rather than later” start to policy normalization by noting in her opening remarks at the press conference that monetary policy “operates with a lag,” a code phrase for acknowledging that it is the forecasted behavior of core inflation down the road, next year and beyond, that will ultimately drive the policy decisions in the nearer term (SGH 5/12/15, “Fed: A Hawkish Lift-off, Dovish Trajectory”).
Core inflation is expected to barely budge from its inertial 1.3%-1.4% this year and only to perhaps on either side of 1.75% next year, perhaps in part because policy normalization has begun to remove some of the massive accommodation in the system.