In the week since the Federal Open Market Committee March meeting, a near half dozen Committee member have hit the speaking circuit on a renewed communications drive that will culminate this Friday afternoon with Chair Janet Yellen’s speech in San Francisco on the “New Normal Monetary Policy.”
Despite their best efforts, there remains no small amount of market confusion if not frustration with what are seen as contradictions between the Fed’s post-meeting messaging and the signals the FOMC seemed to be sending with its dovish downgrades to growth and especially those aggressively lower blue rate dots across all three years of the forecast.
So against that backdrop, a few points seemed in order on where we believe the Committee consensus is coming together on the base case policy path and the assumptions that seem to be driving it.
*** First, even if the market remains deeply skeptical the FOMC will ever raise rates, we still expect the most likely lift-off in rates to be in September. We put extremely low odds on a first move before then, not because the data will be lacking, though they probably will, but because the Committee just won’t be “reasonably confident” enough on inflation to pull the trigger over the summer. And although the odds for a move later into the year have admittedly risen after last week, barring a dramatic turn south in the data, there is still a strong lean among a Committee majority to stick to September, in part to move rates closer to 1% by the time stronger wage growth becomes more evident, and to better ensure a gradual ascent in rates. ***
*** Second, that desire for a very gradual removal of monetary accommodation, it seems to us, is the key cornerstone of the Exit policy path. The base case is for a shallow trajectory stretching across the three years of the forecast, more likely than not punctuated with multiple or extended pauses (SGH 3/6/15, “Fed: Getting There”), and whose end point may not necessarily come in 2017 or at the newly lowered 3.5% longer run neutral interest rate. Of course, the pace of rate tightening may also quicken in step, due perhaps to an upside surprise of faster wage growth and/or inflation; it just depends on the data as Fed officials keep saying. The one thing it won’t be is measured in the fashion of the 2004-2005 rate hikes at every meeting. ***
*** Third, underpinning this policy framework is what one FOMC member called a “cosmological constant:” however flattened, the Phillips Curve linkages between unemployment below its longer run levels, now 5% (or less), pent-up wage growth finally emerging, and a slowly rising inflation will soon become more apparent. Clear threads of secular stagnation are woven into the fabric of the Fed’s assumptions, but the massively accommodative policy prevented the damage to output and the labor markets from becoming too structural. From here, policy is shifting to the start to the rate tightening cycle and protecting a long gradual removal of that accommodation without being forced to raise rates so rapidly it derails an extended recovery that offers the best means to the higher business investment spending and productivity gains that, in time, could boost trend potential growth. ***
Indeed, as important as the lift-off is to the markets or how faithful the quarterly blue dot rate plots are to the actual path of the rate tightening that lies ahead, the supporting narrative is in many ways more interesting and more central to revealing the “normality” of monetary policy when exiting from six years at the Zero Lower Bound.
Those Blue Dots and the Dollar
There are two lingering questions still hanging over the Fed’s current communications push from last week’s statement, Summary of Economic Projections, and press conference. For one, there were those irksome 2015 blue rate dots that were dramatically marked down to barely two rates hikes by year-end, or half the level just six months ago in the September dot plot. But the dots may not have been quite as dovish as they looked on first impressions if they are underscoring a higher certainty of rate hikes this year (see SGH 3/18/15, “Fed: September and a Shallow Path”).
The more hawkish Committee members resigned themselves to reality since there was no chance of a March rate hike they and their staff had projected, and had to mark down their elevated dots for this year and across the rest of the forecast. At the same time, many Committee members felt more certain of a rate hike as the projected timing to lift-off neared, and the rate plot this year became more like forward rate guidance and less of a more general assumed policy rate penciled into the forecast brought with them into the meeting.
The confusion, in a sense, is not as much a conflicted rate signaling as much as it is the Fed’s reluctance to explain the role of the dots in the broader communications and transparency policies more clearly. We assume that bit is coming soon.
Another point begging for clarity was the impact of the dollar. It is fair to say that its near term impact has been larger than the FOMC previously thought even a few weeks ago, but less than the market may still be assuming, especially in projecting how far the dollar is expected to rise from here or its ultimate influence on growth and inflation.
While the dollar’s rise was expected and built into the forecasting assumptions last year, it does now look its drag on the export sector has been stronger than expected, while the offset in lower bond yields and especially the dramatic drop in oil prices has failed to extent into this year. It accounts for a good chunk of the growth being marked down this year and next.
Not that we tend to be conspiratorially-minded or that the FOMC would seek to manage market assumptions so cleverly, but the meeting takeaways from last week and some of remarks this week by Fed officials isn’t so much about trying to talk down the dollar as it is to put a bit more of a two way risk in the currency markets. The Fed in fact is expecting the dollar’s appreciation to slow through this year with Europe, for instance, starting to show signs of a clearer recovery.
More to the point, while the dollar in the near term has also imported dis-inflationary price pressures and stoked price competition to push goods inflation lower, by this time next year those headwind restraints on growth and inflation should be reversing, turning into more of a tailwind on both export gains and higher goods inflation.
In the same way, oil’s downward pressure on headline inflation last year and through the first quarter of this year is also likely to dissipate through this year and next. At the same time, the benefit to the lower energy costs look to have been less than expected, mostly because consumers banked their savings on lower gasoline costs rather than spending them. But the boost to growth from higher spending may be still to come as consumers become more confident in the outlook or their wage prospects even if gasoline prices edge upward a bit.
Both oil and the dollar, then, have contributed to a slower than expected growth and lower than expected core inflation. But on the other hand, both should translate into at least some tailwind to economic activity and especially to the higher core inflation the Fed is expecting, or at least hoping to see, perhaps by the end of this year, and certainly next year.
In particular, that dollar effect would be reversing from a headwind to a tailwind to growth and goods inflation – just as wages may be finally rising and pushing up on services inflation as well.
NAIRU and Pent-up Wage Growth
A basic operating premise of the Fed’s base case policy path is that the traditional linkages of the Phillips Curve between unemployment and labor market slack, wage pressures, and eventually upward price pressures will become more apparent in the data in due course. Those linkages have been stretched and flattened, and perhaps delayed by a quarter or more, but not obliterated.
As we noted, there are secular stagnation assumptions in the Fed’s analysis of the economy — the deep cyclical downturn of the crisis in demand, the damage to the labor market, and enormous losses to output that could become structural and leading to a sustained period of a lower real interest rate and declining potential growth.
The Fed’s optimal control framework was however designed to ensure a front-loaded very aggressive monetary easing to limit that damage and to create enough demand that it, in effect, would eventually create its own supply. Perhaps one takeaway from last week’s lowered growth projections was a reflection of how long it will take to ease those secular pressures.
So with the economy still growing enough above its trend potential to generate steady job creation, unless the pace of activity falters this year, the headline unemployment rate should push through its longer run levels by the turn of the year even if estimates of NAIRU are being nudged down as expected to as low as 5% (or lower).
The Fed does expect the pace of the declines in headline unemployment to slow through the year as more part time workers join the full time labor force — keep an eye on the BLS’s index of total hours worked — or are joined by the discouraged and long-term unemployed. That, in turn, should have mixed effects on wages, with the more skilled among this slowly expanding labor force able to demand higher wages — indeed many won’t be lured back into the labor force without them — while the entry of the lower skilled part time workers into full-time employment may weigh on overall wage gains.
Wage growth is always the last leg of the labor market healing, and at some point on the other side of NAIRU, more broadly-based wage growth should show up in the data across the labor markets. Indeed, those pent-up wage pressures, after having fallen far less than they could or should have in the depth of the recession, could soon rise quite quickly, and as, or if, they do, the long-expected upward push on inflation should finally become more apparent.
And if the Fed’s central tendency forecast is more right than wrong, that upward wage push on inflation could come exactly when the dollar’s downward pressure on prices could be reversing, adding further to an upward path in inflation. Under that scenario, the last place the Fed would want to be is at a zero interest rate.
A More Symmetric Balance of Risks
Exactly when, of course, is the question; previously this turn in the inflation dynamics was expected as soon as the turn of the year, but it could now be pushed back a quarter or more.
But then, maybe not, and that is the basis for the dovish case for a cautious delay in the first rate hike, especially if amid such uncertainty and the possibility the neutral interest rate is indeed far lower than believed, even the smallest tightening could dampen the recovery, and the Fed could soon find itself reversing itself, exactly as the Bank of Japan, the ECB, and the Swedish Riksbank did. The cost/benefit calculations are still strongly asymmetric: the cost of repairing the damage of a premature rate hike still exceeds the cost of being slow to respond to a rising inflation.
But perhaps the single most interesting thing we heard in Chair Yellen’s press conference last week was her assertion that that risk trade-off may be more behind us than in front of us, and if this is indeed a majority Committee view, and our sense is that it is, then this removes one of the key planks to the dovish case to delay a rate tightening into 2016 as some in the markets now expect.
Indeed, it is our sense the consensus momentum is building in the other direction, that due to the nature of the core inflation dynamics — inertial for a long time, resistant to being pushed much lower than the 1% to 1.6% range of recent years but once moving up, resistant to policy efforts to slow it — the balance of risks is shifting more towards a lower tolerance for overshooting the 2% inflation target, or at least purposely engineering an overshoot, for too long or by too much.
The balance of risks, then, when the Fed is now so close to meeting its mandate on unemployment, is now weighing towards timing the start to a rate tightening cycle to slowly restrain that inflation momentum, admittedly still nowhere to be seen but in the models.