Fed: The Minutes, the Morning After

Published on January 9, 2014

There were two immediate takeaways for us in reading through the Federal Open Market Committee December meeting Minutes yesterday afternoon. The first was how cautiously or even anxiously the decision to taper was taken; the second was how prescient the move is looking in light of the better looking data ever since.

There were all sorts of interesting bits and color to the Minutes, but taking them forward leads us to the following expectations:

*** The battlelines will quickly shift from the pace of the taper to the credibility of the rates guidance. Indeed, as we noted before the holiday break was likely to happen (SGH 12/20/13, “Fed: Well Done, But a Testing to Come”), the lower for longer rate guidance is already being challenged, and a robust defense is likely to be forthcoming.***

*** That doesn’t mean the “dots guidance” will not be moving off their extremely dovish rate levels of the December first year and year-end projections; instead and again, assuming the data remains robust, the guidance could point to higher rates, but rates that will still be lower and flatter than where they would be under a more traditional Taylor rule type rate tightening. ***

*** On the taper itself, a pick up in the pace could come as soon as the March meeting if stronger numbers continue deeper into the first quarter. Under that scenario, the Fed could even be out of QE altogether as early as its July meeting rather than later in the year. ***

The FOMC, in other words, may find itself fighting a more aggressive market pricing through at least the first half of this year. At the same time, the FOMC led by its new chair Janet Yellen, is unlikely to be as dovish as she is presumed to be, just more dovish than any persistently aggressive pricing by the markets.

A “Good Enough” Forecast

Across the Minutes, there seemed a certain wariness to the forecast of what Chairman Ben Bernanke would later describe as a “cautious optimism” on the outlook in his recent speech in Philadelphia: the forecast risks to real GDP growth were to the downside, it was noted in the Minutes, the much sought “substantial improvement” in the labor market was “likely” to be met in the coming year “if” the economy evolved as expected, and there was a scattering of low inflation concerns  in several high profile places in the Minutes.

But while the forecasts weren’t necessarily giving the all clear for a sustained recovery, the numbers were “good enough” to put the the taper squarely on the table without further ado, especially as noted in the Minutes, when market expectations were looking so nearly aligned with the Fed’s own expectations on growth and most pleasingly, the forward rate path.

Would there ever be such an alignment of the stars again, or when doves sans one, centrists and hawks could all agree to a policy consensus, even if for different reasons?

Nevertheless, a first taper would have to be very small, would need to be “measured,” and would be need to be wrapped in dovish language that clearly indicated how policy would remain abundantly accommodative. The very dovish positioning of the dots guidance in the Summary of Economic Projections also helped to fully reinforce the intended messaging.

But that said, of course, the start to the taper is making the FOMC look pretty good in light of the data ever since. Those healthy looking numbers are pointing to a solid-looking first quarter and, in contrast to the previous false positive starts the previous three years, that this just may be the year the recovery reaches its long sought escape velocity of a self-sustaining pace that lifts the economy free of its vulnerability to downside shocks.

Indeed, the market is already trading that way, and as we forewarned last month, it is likely to continue challenging the Fed’s forward policy guidance on lower for longer rates. Until the Fed pushes back to defend the credibility of its forward policy guidance, the market will invariably be bringing the first rate hike forward and steepening the rate trajectory into 2016.

If the stronger data continues, we suspect it will open the door to a possible acceleration in the pace of the taper. The first opportunity to do so would be the March meeting, when the next quarterly Summary of Economic Projections is due and will the first chaired by incoming chairperson Yellen. And if the pace of the taper is picked up a bit on the back of persistently stronger data, it could even put the Fed on a new path to be out of QE altogether as early as its July meeting.

Perhaps adding to the bias to wind down the bond purchases sooner rather than later is the concern over the effects of QE on financial stability and the distortions to market functioning. That curious QE survey described in the Minutes concluded things are just fine with the bond purchases, but there was also an unmistakable shared view that the impact of the bond purchases was probably diminishing.

Lower for Longer Credibility

We still think it likely a fairly robust defense of the lower for longer guidance credibility will be forthcoming in upcoming speeches and remarks by various Fed officials, and most obviously needed, from the incoming Chair Janet Yellen, who is the Fed official most closely identified with the so-called optimal control framework.

The key to how to understand the optimal rate path against a backdrop of stronger data is the “lower for longer” is relative to a more traditional path built on Taylor Rule assumptions, not a commitment to the current extremely low level of rates, or even to the most recent levels projected in the SEP dots.

It is not that the forward guidance on rates will not see the SEP dots on the first rate hikes or the year-end fed fund rates projections move forward and up — they invariably will in light of any forecast revisions bringing the central tendency above its upper range. It is just that the path will nevertheless be running well under and behind a Taylor Rule path — and what is likely to be much more aggressive pricing by a bond market seeing growth bursting forth everywhere.

Likewise, bear in mind more FOMC members have been steadily moving their longer run neutral fed funds rate estimates south of 4%, as evidenced in the SEP charts that accompanied the statement. That neutral is a variable rather than a fixed target is what Chairman Bernanke has been alluding to in the last two post-FOMC meeting press conferences.

And on a cautionary note, we also think what could be called the “Stein thesis” — so named after the seminal speech early last year by Fed Governor Jeremy Stein about QE’s costs versus its benefits in light of excessive risk taking and a reach for yield —  will invariably resurface even after QE is brought to a close.

As the Minutes seemed to hint, rates held so low for such a long time — five years and counting — will inevitably at some point have just as much potential negative effects on market dislocations and stability as the bond purchases. Doves will not like that, but that is where the momentum seems to be heading as a policy theme later this year.

Finally, we think all of this is pointing to a Yellen-led FOMC that will not be as dovish as she is assumed to be but hardly as hawkish as the market may invariably end up in the face of better growth numbers.

In addition to the improving outlook, the rotation to new, more hawkish voting members of the FOMC and the arrival of new Governors who may look to find a voice or to lift their public profile are all pointing to an FOMC tilting to a more hawkish lean.

Above all, there is Yellen herself. She is more of a tactical than an ideological dove, and above all she is no longer soley exerting her influence from the side as a District President or even a Vice Chair, but she will be tasked with forging a consensus among 18 strong-willed colleagues. That almost by default will point to a more center-left position in the FOMC’s policy spectrum.

But as we noted, we just suspect it will nevertheless remain more dovish than the market pricing, which will inevitably mean a Fed that will be pushing back on higher yields for as long a the strong data points continue.

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