Fed: The Dots and the Trajectory

Published on September 23, 2014

There seems to be a lingering confusion since last week over what many took to be crossed signals between the Federal Open Market Committee’s dovish statement versus the more hawkish “blue dot rate plot” indicating a quickened pace of rate hikes.

Only adding to the confusion was an odd Wall Street Journal story this morning that the retirement next spring of Philadelphia President Charles Plosser and Dallas Fed President Richard Fisher would somehow tilt the consensus within the FOMC on rate hikes a quarter point lower.

So a quick note to make two points:

*** The easiest way to reconcile a dovish statement on the near term policy path with the more hawkish takeaway of the blue dot rate plot projections is the inherent trade-off at the heart of the optimal control framework the Fed has been more or less working within ever since the scariest moments of the financial crisis in 2008. As then Vice Chair Janet Yellen noted in her “optimal control” speeches in 2012, an aggressive front-loading of a highly accommodative monetary policy in the optimal control model may warrant a symmetrical offset in a willingness to raise rates more rapidly if necessary. ***

*** The projected rate path during the three year horizon of the forecasting period did rise more steeply, and it does put a modestly more hawkish spin to the rates outlook (SGH 9/17/14, “Fed: A More Rapid Ascent in Rates”). But the blue dot plots are only the Board and District staff’s modeled assumptions of the appropriate policy path used by Committee members as contextual background going into the FOMC meetings. The dot plots are not meant to carry the same weight as the actual forward guidance voted on by the Committee and put into the formal statement. ***

For our two cents, we still believe June next year will mark the most likely lift-off in rates — the fulcrum around which the “sooner or later” messaging rotates — and that regardless of the blue dots, it is likely to be a gradual tightening through at least an initial phase to give the FOMC time to assess how quickly the higher rates are being transmitted across the yield curve and into the real economy.

And if we were to use the dot plot as a guide, we would weight a cluster of ten to twelve center dots for a year-end 2015 fed funds range of 0.75bp to 1%, or maybe at 1%-1.25%. After that, it will depend on the data as so many Fed officials keep saying, but the pace of rates is likely to steepen, though perhaps not as much as suggested by a midpoint to all 17 of the current dots. That said, it is still likely to be steep enough to reflect what may prove to be a successful monetary policy to get to full employment without the risk of sustained higher inflation down the road.

The Optimal Control Trade-off

Our understanding was that the intended takeaway from last week’s statement was to lay out a near term dovish policy path. There is a watchful eye on housing, whose current weakness is adding to the dovish-leaning caution, while the softness in the inflation measures by a bit more than anticipated was already enough to warrant the downward tweak in the statement’s inflation language to note inflation “running below” the longer-run objective. At the same time, September Non-Farm Payroll breakdown will be closely scrutinized to gauge any change in the noise relative to the signal in the data of steady improvements in the labor markets.

But beyond worry over unforeseen shifts in the direction of the data, in general, the dovish near term messaging is more or less a reflection of a FOMC majority’s determination to keep the guidance highly accommodative until a “white of the eyes” confirmation an “escape velocity” of a self-sustaining growth is firmly in sight.

That means, as we have been writing, a delay for as long as need on the signal to a rates lift-off, which we think makes the December meeting the earliest possible moment when the FOMC will weigh a substantial change in its forward guidance (SGH 8/19/14,”Fed: The Minutes, Jackson Hole and into September”).

The hand-wringing over the fate of the considerable time” language is likely to fade as an issue in the coming weeks after Chair Janet Yellen so thoroughly neutered its policy signaling significance in her press conference last week. It would be more natural for it to come out in October with the end of the bond purchases, but it will just depend on the data in the run up to the meeting and what will be the most tactical means of maintaining a policy neutral stance in signaling the likely timing to a rates lift-off.

As we noted, we still think that points to a June lift-off in rates, though the FOMC is certainly keeping its options open to move in the spring or to delay until the fall. Optionality until December at minimum, then, is the objective in any guidance and messaging changes in the coming weeks.

But it is probably the pace of the rate hikes after the first rate hike that is drawing so much of the market attention. And on that front, it would be hard not to notice how Chair Janet Yellen did her best to shrug off the upward drift in the quarterly blue dot rate plot projections. New York Fed President William Dudley did the same yesterday suggesting the market shouldn’t “overweight the value of the dots.”

We do think that is the case for the most part, but only if the upward drift is placed in the context of the models and assumptions used to nudge the dots to a more rapid ascent, and why.

Our sense is that the upward drift in the dot plots reflects the modeled path of rates under the optimal control framework, whereby the front-loaded accommodation may need to be offset on the other side of a self-sustaining recovery with a symmetrical willingness to raise rates more rapidly if core inflation is threatening to rise above its 2% target on a sustained basis.

Indeed, if the economy performs anything like the FOMC September Summary of Economic Projections over the next three years, the pace of the rate tightening may rise more steeply than anything like the majority of FOMC members believe and have been messaging in their speeches and interviews, including Chair Yellen.

The September SEPs are forecasting the headline unemployment rate to fall steadily lower towards and through its assumed longer run rate by the later years of the forecasting period. The narrow central tendency range – which tosses out the top three and bottom three of the 13 board and district staff forecasts – has the unemployment rate falling all the way to 5.1%-5.4% in 2016 and to 4.9%-5.3% in 2017, while the wider ranges show some staff putting the headline unemployment rate all the way down to 4.7% by the end of 2017. That is by anyone’s measure well below even the most dovish estimates of NAIRU.

Growth on the other hand was tweaked down a bit across all three years, but even in 2017 at only 2.3%-2.5%, growth is still above the slight downward estimate in trend growth at 2%-2.3% — meaning, in other words, that even at the slower pace of growth, it is still forecast to be strong enough to be generating job gains.

And while inflation risk may be skewed still to a downside in the near term, and even with a flattened Phillips Curve, the consensus in the Fed forecasts is pointing towards a full employment well below NAIRU estimates that is going to be putting an upward pressure on prices.

Higher Inflation without Steeper Rates

That would especially be the case if, as most in the Fed assume, pushing unemployment through NAIRU should also finally trigger a steady upward rise in wage growth back to a 4% plus pace. Inflation is all but certain then, in the models anyway, to be rising and perhaps beyond the 2% inflation target without tweaking the fed funds rate higher to keep those price pressures tempered.

That the Fed may be willing to “overshoot the 2% medium term inflation target temporarily in the near term is beside the point – for the most part, most of the FOMC is willing to do so; it was already embedded in the 2.5% inflation safeguard threshold for one.

But it is another step altogether to stamp the overshoot into the base case forecast, We suspect the Committee dovish-leaning and centrists are as unlikely to tolerate a sustained rise in inflation as the fiercest of hawks, and that translates — again, at least in the models — into the center cluster of the blue dots being scaling up into a quicker pace of rate hikes.

Almost by definition, then, the dots represent an idealized, most optimistic of scenarios in which nothing goes wrong on either side of the recovery. The actual rate decisions could run above or below the midpoint of the dots projected in each quarterly update, and it will just depend on how the data is feeding into the revised forecasts and how much of a trade-off in the cost/benefit analysis the FOMC might be weighing at that particular meeting.

In other words, none of the Committee members will feel bound by their staff projections on the dots, or the assumed neutral longer run interest rate for that matter.

In any case, barring a derailment in the current pace of the recovery — inflation that defies modeled behavior and continues to drift lower, for instance, pushed down perhaps by the European export of deflation through a lower Euro, or housing that just never quite gets back on its feet — rates hikes are almost certainly coming in 2015, so Martha put on the tea kettle.

But after that, the rate tightening trajectory could quicken in pace, and will probably steepen to some degree, but we rather doubt the world will evolve as perfectly robust as the September blue dot rate plots suggest.

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