Fed: The Lean into March

Published on February 23, 2016

A number of Federal Reserve officials are speaking through this week beginning with Vice Chair Stan Fischer later tonight in Houston. Bracketed as they are between last Friday’s surprisingly strong CPI and an expected similar showing in this coming Friday’s core PCE print, the markets will be scrutinizing the speeches for signs of rising probabilities for a rate hike at the Federal Open Market Committee’s upcoming mid-March meeting.

*** While the odds for a March rate hike were never as low as the market bearish pricing through last week, we believe a March rate hike still remains unlikely. Our sense of the FOMC majority view remains one of caution in messaging a March rate hike amid still volatile markets and an uncertain growth outlook that may only gain clarity by late spring. Indeed, we think the balance within the Committee is already tipping towards three hikes at most this year, with the next rate hike in June. ***

*** A sense of caution in managing market expectations and pricing is another factor going into the likely Committee consensus. A signal-rich second rate hike in March could invariably send the market a too hawkish affirmation on the likelihood of December’s base case four rate hikes this year when the FOMC remains so wary that the tightening in financial condition since the turn of the year could only move tighter still if they even signaled a March rate hike, much less did hike. ***

The Presumed Inflation Dynamic

The 0.3% increase in core CPI last Friday was the biggest jump since 2006 and puts the core CPI at a 2.2%, which most Fed forecasters reckon should lift the core PCE to perhaps 1.6% this coming Friday. What’s more, the unexpectedly higher inflation print was pretty broad-based, and that it came despite the strong dollar and the plunge in crude oil prices was noteworthy.

Indeed, if the steady job creation and tightening in the labor markets continue as projected, the US economy may be seeing a bottom in the long, lonely persistence in low core inflation. And if anything else, the inflation numbers last month should grant Fed officials some satisfaction that their Phillips Curve assumptions of more powerful and sustained domestically-driven price pressures look to be battle-tested as a useful analytical framework.

But at the same time, January tends to see base effects, and the Fed for its part seems to be still assuming the rise, while welcomed, will level out through the spring. Instead, a steadier, more durable underpinning to higher inflation is still not likely to show up in the data much before the second half of this year.

That said, the Fed still believes the rest of the world’s growth will fare far better in the near term than seemingly everyone else on the planet believes, and that forecast includes a slowing but still 6% plus growth in China — that is certainly what Chinese officials will be telling their G20 counterparts (see SGH 2/22/16, “China: G-20 Meeting, Volatility, Growth, and FX”) — despite even the FOMC’s own fretful anxieties expressed in the January meeting Minutes.

That will or should translate into a stabilizing dollar and a modestly higher oil price — which we have highlighted in numerous reports seems likely in the wake of the shift in Saudi oil policy (see SGH 1/21/16, “Saudi Arabia: Lending a Hand”) — and the steady fade in the downward pressures on goods prices through the year. Higher headline price measures should steadily seep into higher core prices, certainly by the second half of this year.

And as we have noted previously (see, for instance, SGH 11/20/15, “Fed: Affirming Sooner and Slower”), the whole point of the “sooner” start to policy normalization was to maximize the FOMC’s policy flexibility to slow or quicken the pace of rate hikes, depending on the data, whether the inflation dynamic is unfolding as expected, and whether the markets can or will make the necessary adjustments as smoothly as possible.

One nagging, irritating really, question though that hangs over this scenario is the no-show for a bigger boost to aggregate demand in the dramatic drop in gasoline and energy costs. All sorts of reason are being weighed in staff research, among them that the faster-reacting financial markets are transmitting the downside effects far more quickly than benefits to consumers or businesses, whose lack of confidence in the outlook leads them both to squirrel away the savings into cash at the bank.

The Fed for the most part still sees a lower energy price boost to demand as delayed not denied, but if truth be told, they are not sure why it has been so slow in coming. Perhaps Vice-Chair Fischer will address the energy and monetary questions in his remarks tonight — he is speaking in Houston after all — but it would not be an understatement to note the drop and outlook for oil prices is adding complicating cross currents to the Fed’s near term policy path.

Looking Ahead to June

That, in fact, can be added to the reasons for caution among many FOMC members in passing on a March rate hike. With no pressing need in the real economy, the probabilities on that second rate hike shifts to either April — which is problematic unless Chair Janet Yellen explicitly makes the meeting truly “live” by pre-announcing a press conference to follow — or as we strongly expect, the June meeting.

Not only does June offer a press conference and the Summary of Economic Projections — perhaps with their new “fan charts” — June should also provide far greater clarity on the economic outlook and whether inflation is indeed playing out as expected.

Equally important, it will provide that long runway for the market to shift its pricing in anticipation of a rate hike, as the Fed mapped out the rate path last year from the August market volatility to the December rate lift-off. That is an attractive calculation for an FOMC keen as ever to ensure a smooth as possible transmission of a rate hike to the real economy without being undermined by an excessive market reaction.

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