Another hike in the target policy range to 1.75-2.00%, which would put the fed funds rate within striking distance of the bottom end of many neutral estimates, may in fact turn out to be the least of the policy takeaways from this week’s meeting of the Federal Open Market Committee.
Instead, much of the market attention may invariably be drawn to how Chairman Jerome Powell handles inevitable press conference questions about the neutral rate, the statement guidance language, and the balance sheet issues going forward — perhaps even enough to drown out the usual fanfare over the always problematic rate dot plots.
*** An extended debate over estimates for neutral, and how this should reshape statement language and when, is likely to dominate much of the discussions at this week’s meeting. There is a decent possibility the Committee may signal a near enough proximity to neutral to begin what we expect will be a two-step transition in the guidance language from policy normalization to a data- dependent policy path; but, on balance, we suspect it is a bit too early to do so, though at minimum, Chairman Powell will use the presser to map out coming changes in the forward guidance language. ***
*** Along with the 25 basis point increase in the target policy range, the FOMC is also very likely to set a lower 20 bp increase in the Interest on Excess Reserves, or at least they better if they want to avoid a self-inflicted pop in money market volatility. But we do not expect any announced changes in balance sheet policy, and on inevitable questions about its terminal size and the eventual operational framework, we doubt Chairman Powell will offer detailed comment, as we think it is still an active debate with a decision unlikely until perhaps the September meeting. ***
*** Overall, our best sense of where the Committee consensus stands suggests that Chairman Powell will seek to stick to his “middle ground” narrative, pushing back against any excessively hawkish (or dovish) market reaction to movements in the rate dots, changes in the projections, or statement language. Despite the solid recent data, we doubt the FOMC majority sees enough momentum in inflation that would warrant a more hawkish policy stance, we still think, until probably the September meeting. ***
A Full Early Summer Agenda
The June FOMC meeting will have a full agenda on the table, and will be set against the backdrop of multiple market attention grabbing events, among them the historic meeting in Singapore between President Trump and North Korea’s Kim Jong-Un, a meeting of oil superpowers in Moscow on the sidelines of the World Cup between Russian President Vladimir Putin and Saudi Arabia’s Crown Prince Mohammed bin Salman, not to mention the European Central Bank and Bank of Japan policy meetings.
In terms of our expectations for the rate dots, we still expect the 2018 rate dot median will stay at three hikes rather than four. We in fact think there is perhaps as much chance for any individual four hike rate dot moving down to three as there is for a three rate dot being nudged up to four.
We are unsure of the most likely movement in the 2019 and 2020 rate dot projections at this meeting, but as we wrote previously, by September in any case our sense is that the rate dot trajectories could flatten somewhat, but the tightening cycle extended into 2021 (see SGH 5/22/18, “Fed: A Honeymoon’s Second Doubts”).
But perhaps the most important takeaway on the rate dot front will be what we think is a likely pushback by Chairman Powell in reading too much into the rate dot projections, for instance, in a fourth hike this year making it into the median; after all, the whole point of where the FOMC is generally headed in terms of its communications policy is to move away from forward guidance and to a meeting to meeting data-dependent decision-making — and the rate dots are not meant as guidance in any case.
In terms of the Summary of Economic Projections, we doubt there will be much movement in the medians, with most of changes in real growth and inflation forecasts showing up in a wider dispersal in the full ranges of the Committee forecasts before they are topped and tailed for the central tendency. The median in any case, for core inflation is likely to remain unchanged, and same with median for trend growth and the longer run neutral estimates.
But the median 2018 headline unemployment rate projections will certainly be marked down still further, again, to at least 3.8% and probably well on its way to the 3.6% level already penciled in for both 2019 and 2020. That is nearly a full point below the longer run unemployment estimates, though there is a pretty good chance it too will be tweaked down to 4.4% from 4.5% and 4.6% in December.
More to the point, however, as anxious as the very tight labor market makes even the most dovish Committee member, at the same time even (most of) the more hawkish Committee members don’t see any gathering momentum to the underlying trend inflation. It is more of a 2019 story, and as long as that assumption is confirmed in the data over the next few months, Chairman Powell and the Committee majority will remain fairly confident they can be patient in continuing with their gradual pace of rate hikes.
So while the data have continued to be solid, supporting the Fed’s gradualist approach to neutral, we doubt the Fed will see the numbers as being so strong that they require a change in the policy messaging on pace of rates normalization.
R* and Language Changes
But what makes the June meeting interesting is whether the FOMC will opt to begin the transition in the guidance language. Several Committee members, including Chairman Powell and New York President designate John Williams, have been hinting in recent weeks the current statement language is starting to get past its sell-by date and needing to be changed relatively soon.
It is worth considering now whether the FOMC could begin what we think will be a two-step transition in adjusting the statement language on the two boilerplate guidance sentences affirming the gradual rates normalization strategy that means monetary policy remains accommodative, and that rates will remain below normal neutral levels for some time.
On balance, we think they will wait until the August 1 statement at the earliest, but it is a call without too much conviction. The Committee could just opt to keep the key phrases in place until they are very confident that are well into the neutral range and simply change the language all in one go. We doubt that though, and suspect the appeal of gradualism will appeal to language adjustments as well as rates.
And in any case, language changes will depend on whether the FOMC can get to a consensus on where they best estimate the equilibrium or neutral policy rate to be, or at least where the bottom end of the range around the neutral estimates lies. Implicit in that is whether a consensus can be crafted on whether the Committee thinks the estimated short run R* is indeed rising this year and early next towards its longer run levels.
Our sense, though, is that going into this week’s meeting, there is little of a consensus on the neutral issue. Some Committee members are thinking the short run R* is unlikely to move in the near term much beyond what most on the Committee seem to put at a real quarter point or a tad higher, or as Governor Lael Brainard seemed to be saying in her speech just before the pre-meeting black out, that the short run R* is in fact likely to be fast rising above its longer run estimates; in effect, she is going along with the consensus on the need to move rates higher in 2019 and 2020 but her reasons differ in that it won’t be an outright tightening above neutral, but rather the higher rates are needed to keep pace with a rising neutral.
In any case, we think the still wide range of estimates on neutral and the short run R* estimates may preclude a shift in the statement language just yet. But at minimum, Chairman Powell will probably lay out the possible changes, and the need for adjustments, in his press remarks, which could have much of the same effect in market expectations.
Along the same lines, Chairman Powell seems likely to defer on the question of whether a tactical pause is likely once the Fed is safely at neutral, even if some Committee members certainly think it is not a bad idea.
It would also be something of a signposting to mark the transition from a policy path defined by the rates normalization strategy to a more traditional data dependent policy path, whereby rates could rise or fall, depending on the data and the forecast. That is where the FOMC is headed, but then again, the data may not allow the FOMC the luxury of a pause. They will just have to decide when they get there.
It is also unlikely the FOMC will cite “international developments” — be it the Emerging Markets or European dislocations over Italy — in what will otherwise still be “roughly balanced” risks to the economic outlook. We wonder if the Committee, on the other hand, will be tempted to mention “uncertainties over trade clouding the horizon,” though probably not, as it may be a tad too early to do so.
The Balance Sheet Issue
One last quick point is on the current balance sheet normalization strategy in the set levels of monthly run-offs in the Fed’s treasury and MBS holdings. We do not expect any changes in that pace, currently $50 billion in total each month, to be announced at this meeting.
But the FOMC will almost certainly be delving into the issue of which operational framework they will ultimately settle on, whether a return to the reserve-scarcity corridor system is still possible, or as seems more likely, to stick to the larger balance sheet of the current floor system. We doubt there will be any decision on this front until the September meeting, with a lengthy discussion and perhaps even a decision at the July 31/August 1 FOMC meeting when they will have the luxury of more time to review staff work and when they will not be debating a rate hike.
But we would caution against any sense of an earlier than expected end to the balance sheet shrinkage as suggesting the Fed will also end its rate hikes a bit earlier than that penciled into the rate dot projections.
For one, it is our understanding that the rate dot trajectory already has the current pace of balance sheet shrinkage written into the forecast, one would assume at least down to around the $3 trillion mark; so if the balance sheet run-off ended a half trillion dollars or more sooner than projected, it would in theory mean just the opposite, that there is less tightening via the balance sheet in financial conditions and therefore the Fed might need to raise rates even more to get to the target level of tightening.
That they may not in fact ever get the rates up to where the rate dot plots put the policy rate by 2020, or perhaps not much beyond neutral, is and remains a legitimate policy debate. But that is a separate issue from the balance sheet question, which will probably not enter into that debate at this juncture other than at the margin.