Fed: The Minutes, Jackson Hole and into September

Published on August 19, 2014

 There has been no small amount of anxious anticipation of Federal Reserve Chair Janet Yellen’s keynote speech to open the Federal Reserve Bank of Kansas City’s conference in Jackson Hole on “Re-Evaluating Labor Market Dynamics.” But we would also add that tomorrow afternoon’s release of the Minutes to the Federal Open Market Committee July meeting may provide a foreshadowing of the Jackson Hole speech and papers, as well as a useful way to frame the policy path going into September.

*** The Minutes are likely to offer up a mix of both mildly hawkish and clearly dovish takeaways. That the FOMC is advancing its preparations for the lift-off in rates in itself could be taken as a hawkish signal of the movement towards the normalization of interest rates. More importantly, we think the discussion section on the upward tweaks to the inflation sentences may provide a greater glimpse of the relief many dovish members feel about low inflation receding into the rearview mirror and opening the door to thinking about rate hikes. But the section summarizing the reasons to include the sentence that labor resources remain underutilized despite the progress in employment will anchor the dovish expectations for the Fed’s near term policy path. ***

*** While she is likely to acknowledge the “substantial improvements to date,” Chair Yellen can be expected on Friday to give an impassioned (for a central banker anyway) argument that there remains enough slack in the labor market to warrant the Fed’s amply accommodative monetary policy. A prominent theme may also be the uncertainty and difficulty of interpreting the current post-crisis labor market dynamics in the real time of policy making, which in turn, may underscore the Fed’s likely reaction function to the data through at least year-end. Sustained wage growth is likely to be the last piece of the labor market puzzle, but the pay-off in pushing to and through NAIRU will come in ultimately reversing the decline in the economy’s trend growth potential. ***

*** For a majority of the FOMC, the policy signal that the countdown to a rate lift-off has begun is likely to be as or more important than the rate hike itself. For that reason, many prefer to hold off until the December meeting to make the judgment call on whether the long sought “escape velocity” to the recovery and the essential wage gains are more certain in the forecast. That means in addition to the crowded September meeting agenda, a staggering of intended tweaks to the guidance is likely to run from September to at least December, including a fix to the “considerable time” phrasing of the guidance that is tied to the end of bond purchases, probably in the October statement. ***

A note of caution is that these incremental transitions in the Fed’s policy messaging may end up so nuanced, so gradual, that a fixed income market already burned several times in pricing higher rates and yields so far this year, will tend to ignore the signals until the day of reckoning with the rate hike itself, unleashing an even uglier version of last summer’s “taper tantrum” volatility the Fed is trying its best to temper.

First, on the Minutes

There is likely to be a little of something for everyone alike looking for hawkish or dovish clues to the evolution of the Fed policy path in the July meeting Minutes tomorrow.

On the hawkish side, the section detailing what looks to have been lengthy discussions on the mechanics and sequencing of the Exit should in itself underscore that the FOMC is preparing for a rates lift-off, however skeptical the market may be that rates will ever go up. The FOMC is hell bent on wrapping up the Exit discussions at the September meeting, and to unveil the new sequencing and clarify some of the finer points of the operational details in an attachment to the meeting statement and in Chair Yellen’s post meeting press conference.

Most of the essential outline to the new Exit sequencing are known: the Committee is strongly leaning towards holding off on the end to the reinvestments until or after the first rate hike. But even that is not a lock, however, as some note it may send somewhat contradictory signals to be raising rates while still essentially buying more bonds even if it is just to keep the balance sheet level. Others caution the end to the reinvestments could still be a useful tactical device to signal the time frame to rate hikes if it looks possible the rate hikes are going to be put off deep into 2015.

The Committee does seem committed, however, to hanging on to the federal funds rate as the policy target, even if it will have to be announced in terms of a range until enough reserves are drained or sterilized to give the Open Market Desk better odds on hitting a level. And somewhat surprisingly, at least in the near term, the Committee looks to be more coolly apprehensive about relying too much on the new overnight reverse repo rate, instead delegating it to a secondary role to ensure a floor to the fed funds range, with the Interest on Reserves being reserved as the primary policy tool to lift the effective funds rate.

But one issue the FOMC may have discussed – we certainly hope so anyway – is the role the blue dot rate plot of the Summary of Economic Projections will actually play in the rate policy decisions on the timing to lift off and especially the likely trajectory of the tightening. There is enormous confusion on this front mostly, frankly, of the Fed’s own doing. There is also no small degree of confusion over the merits of trying to price short rates as a median or weighted midpoint of the dots, or even whether the dots are effectively the IOR, with a discount thus needed to price the expected fed funds rate. Some of this may come up in the Minutes, but either way, the Fed will need to come forward to offer some clarification on all these issues, certainly before the 2017 dots are unveiled in September.

Another important thread, we expect, will be how the Minutes treat the debate over the tweaks to the inflation sentences in the statement to indicate a modest movement towards the mandate of a 2% medium term inflation target. As we wrote previously (see SGH 7/24/14, “Fed: Calibrating the Guidance for Lift-off”) we understand the tweaks to reflect an important underpinning to the very incremental but important shift underway this summer among the more dovish Committee members as the low inflation fears slowly fade.

We do think it likely no small amount of attention will also be focused on the discussion section dealing with the inclusion of the “underutilization of labor market resources” sentence into the statement. That sentence is a second dovish anchoring to the forward guidance this year by the Yellen-led Committee, the first being the March inclusion of the “below normal” longer run neutral rate.

The July statement “underutilization” sentence was meant not only to shift the labor market focus from the headline unemployment rate to the broader array of job measures that better capture the degree of slack in the labor market; it also serves as a neat encapsulated foreshadowing of Chair Yellen’s most likely themes on Friday morning at Jackson Hole.

The “Speech”

Those hoping or expecting a hint or policy signal in the speech are likely to be disappointed. It has not really been Chair Yellen’s style to drop explicit hints at policy shifts in her speeches, preferring instead to let the formal statement provide the lead to shifts in the guidance, and her speeches to affirm and elaborate on a shift in policy signals.

Nor is she wont to steer too far ahead of the Committee consensus — the latter is one reason why July’s under-utilization sentence is so conveniently timed — so nothing of her predecessor Ben Bernanke’s “QE2 is coming” speech in 2010, after which he promised his irritated Committee colleagues he wouldn’t front run them again. And finally, there is no particular reason Chair Yellen would need to alter the main thrust of the current forward guidance.

There has been without question substantial improvements in the labor markets over the years since the depth of the recession in 2009, which she will no doubt acknowledge and to which she may offer at least some credit to the Fed’s expansive accommodation in lieu of any help on the fiscal side or negative shocks from just about everywhere. But for the most part, Chair Yellen can be expected to give a well-reasoned account of the reasons the Fed believes there remains enough slack in the labor markets to warrant a continued highly accommodative policy.

There will be, no doubt, a carefully reasoned analysis of the various data points of the so-called dashboard she introduced about a year ago — the still high level of people working part time for purely economic reasons – i.e., no full time jobs on offer — or the discouraged who have given up looking, not to mention a still too high headline unemployment rate, however much it has fallen relative to expectations, all of which are for reasons that can be explicitly traced back to the cyclical shortfall in demand that would spur more hirings.

She may also delve more deeply into a somewhat more contentious but important argument that policy needed to be as highly accommodative as it has been and needs to be in order to repair and reverse some of the damage to the labor markets and to the economy’s productive capacity to ensure it does not become more permanent and structural, pushing the economy’s trend growth potential on a steady decline.

This is the likely “eyes on the prize” part of the speech if it is included: the “secular stagnationists” can be proven wrong if policy works enough to create enough demand, pushes the unemployment rate down enough to and through NAIRU that it pushes wages up faster, draws in still more workers off the sidelines or into full time work, and a virtuous cycle gets underway with higher investment spending in worker training and productive capacity that trend growth potential is stabilized and rising again.

That willingness to probe towards or through NAIRU is also driven by a recognition across many in the Fed system that the desired level of wage growth will only tend to build the closer the headline unemployment rate gets to its longer run levels.

There is a view inside the Fed that it will not be until the unemployment rate is getting down towards 5.5% that this much sought growth in wages will rise up from its too low 2% or so levels of the last few years to the 4% or more needed to ensure a sustainable aggregate demand growth and to keep inflation from slipping back down again.

Uncertainty and the Reaction Function

We also suspect one of the more prominent themes to the speech, and in the academic papers and discussant remarks that follow, will be the uncertainty and difficulty of assessing the post-crisis labor dynamics when so many of the previous assumptions and relationships that would have been penciled into the forecasting models have broken down: just why has the headline unemployment rate fallen so fast relative to the slower GDP growth? Will the labor participation rate really rise, however modestly or even stabilize, despite the downward weight of the demographic trend? Or where does the desired wage growth fit into the inflation process, especially its crucial early phases?

In addressing that uncertainty, Yellen will in effect be providing a clue to the Fed’s reaction function to the data as it comes in through the end of the year. Fed officials have all stressed policy is “data dependent” (really, “forecast dependent,” but that is splitting hairs) as one piece of its shift to “qualitative guidance; but it doesn’t actually mean a whole hell of a lot because the issue is how the Fed is likely to react to the data that everyone else can also see and interpret.

Whether explicit or implicitly stated, we suspect Yellen will be strongly steering the reaction function to one of caution, the “white of the eyes” approach Atlanta Fed President Dennis Lockhart described in recent remarks, and above all, to a steely patience and discipline to refrain from a pre-emptive response to stronger data. At least we think, through the end of the year…

Again, for Yellen and a solid majority of the FOMC, the pay-off in the push towards the Fed’s employment mandate is worth the risk of a possible upward drift in inflation. After years of persistently low inflation amid such elevated unemployment and an enormous output gap, the belief or bet has been that inflation will tend to trend sideways, neither drifting further down into Japan-style deflation (at least not in this cycle) nor spiking in any sort of expectations-augmented accelerationist inflation of the 1970s; disco is truly dead, and so is that sort of “behind the curve” inflation threat.

The cost in being wrong on inflation, for now, is still far lower than the cost of a premature tightening – or a signal of a tightening – that could threaten to derail a recovery that this year is finally showing evidence of ratcheting up in pace to a near 3% trend line from the disappointing “year after year” of a subpar 2% or less growth of the last few years.

Hawkish Threads to Year-End

If this is how the speech and the debate over the two days of the Jackson hole conference does indeed play out — and we think it will — we also think there will be some hawkish threads throughout the deliberations in the concluding takes by the departing media in their weekend wrap-ups of the conference. After all, Chair Yellen is very much a mainstream new Keynesian, and the Committee, for all its diversity of views, all agree on a desire to break free of the zero lower bound and to normalize rates as soon as realistically possible.

To dial back to some of our themes in earlier reports (see SGH 7/24/14, “Fed: Calibrating the Guidance for Lift-off,” SGH 7/30/14, “Fed: An Option Just Exercised,” and SGH 8/1/14, “Fed: From the NFP to Jackson Hole”), we do think there has been a very subtle summer shift in the “lean” of the Committee in that the burden of proof is falling on those either arguing for a lift-off in rates prior to the June or after the September meetings next year.

Jackson Hole may or may not add just a little sliver of the same cautious movement, but we do think by mid-September of this year, when the FOMC sits down again for a pivotal two day meeting, there will be the start to upward tweaks in the forward guidance — assuming of course the data does not disappoint.

The unexpected dissent by Philadelphia’s Charles Plosser may have been for such technical reasons it softened somewhat its edge. But it is nevertheless a marker being put down that changes to the guidance with less accommodative language will be on the agenda lest there be one or more dissents this time round instead of just one.

Since, however, the divide between the proverbial hawks and doves of the Committee is not actually all that great (we believe), it may prove to be easier than advertised to get to the sort of fine-tuned guidance than might be feared.

Even the more Taylor-Rule driven hawks on the Committee are to at least some degree willing to give Yellen and the like-minded some running room to push the unemployment rate down further still to test whether it will indeed drawn in additional workers, while doves as we noted earlier are past their low inflation/deflation fears and are coming round to discussing the timing to rate hikes. The issue instead, boils down to how much and how quickly to begin recalibrating the guidance to better position the central bank by year-end, or God forbid, if they are wrong on dampened price pressures.

For one, as we have noted before, the September agenda is a crowded one, and the need is to focus the Fed messaging on just one or two items — the new Exit Principles springs to mind for one, not to mention finally clarifying the role and place of the increasingly infamous blue dot rate plots for another. That in practical terms seems likely to mean the tweaks to the guidance we are expecting are more likely than not to be staggered across the three meetings until the end of the year rather than in any sort of more decisive “big bang” shift to the guidance in September.

For instance, the FOMC may opt to punt on what to do with the linkage between the “considerable time” of its highly accommodative policy and the end to the bond purchases until they absolutely have to, the October meeting statement in other words (ignoring for a moment the ideal of a press conference to explain it in more detail). So, in other words, we do think the language will be tweaked to remove some more of the “highly” accommodative tone to the guidance, but perhaps not by a lot.

That “take it cautiously approach” may prove to be even more of the case since many Committee members are increasingly yearning to put off the crucial decision on whether the elusive escape velocity in the recovery or the much sought wage growth is indeed baked into the forecast for as long as reasonably possible before signaling in the guidance a countdown to a rate lift-off is underway.

For many Fed officials, after some six years at the zero lower bound, the signal to hike is as or more important than the rate hike itself. With the memories of the 2013 summer “taper tantrum” still freshly seared into the Committee thinking, that, in turn, points to a December moment of reckoning. After all, what is the rush?

Ominous Geopolitical Clouds

One other point on that front, that may be even more likely if the ominous geopolitical clouds, be in in the Mideast, China, and especially the Ukraine and Europe’s faltering growth prospects, are still hanging over the FOMC by the time they sit down for their two day meeting in mid-September. All of these are early days and are highly unlikely to show up in the Fed’s forecasts just yet, but if those clouds of concern are still hanging over the discussions during the meeting, it may influence the mood enough to add weight to a dovish caution.

For the markets, after being burned two or three times in positioning for the long awaited “Turn,” there are lingering doubts the Fed will ever raise rates. So there is no small risk that the Fed’s ever so slowly coming adjustments in its guidance to prepare the market for the coming rate hikes may simply be ignored or not heard.

The only thing that may grab the market by the lapels in this situation is loss, perhaps big losses: the rate hike, however well telegraphed, when it comes, could cause the very dislocations in the financial markets the central bank has been striving so hard to avoid in order to safeguard the recovery in the real economy. We suspect the moment of truth will come no later than December, if not before.

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