Fed: The Minutes, the Testimony, and into March

Published on February 18, 2015
SGH Insight
"June, in other words, is when the FOMC is more likely to make its decision on the lift-off timing rather than when it actually pulls the trigger on that long-awaited first rate hike. Indeed, we still see a more prudent building of consensus in the Committee from June into September as the most likely meeting for a rates lift-off"
Market Validation
(Bloomberg 02/18/15) "May/Aug 2015 fed fund futures spread at 13.5bps, implies 54% probability of a 25bp rate hike at June or July FOMC meetings after Jan. 27-28 minutes showed many officials inclined to stay at zero longer."

This afternoon’s Minutes to the Federal Open Market Committee January meeting should serve as a prologue of sorts to Chair Janet Yellen’s twin Humphrey-Hawkins testimonies on Capitol Hill next week, and between them, provide a sense of the FOMC consensus going into the pivotal mid-March meeting on two issues foremost to the markets: the fate of the patience language in the March statement and whether Chair Yellen will confirm June for a possible lift-off in rates.

*** We expect the Minutes to indicate the FOMC is indeed searching for alternative language formulations to the two-meeting “patience” guidance (SGH 2/6/15, “Fed: On the Mark”). Ideally, the FOMC wordsmiths will find new language or adaptations to the patience phrasing that maximizes their flexibility on the lift-off timing with a minimum of market dislocation that keeps June on the table but narrows the window to no later than September. ***

*** The longer run unemployment rate is also likely to be tweaked lower again in the annual “Statement on Longer Run Strategy and Monetary Policy,” while the Minutes may include a revisit to the management of the balance sheet – an issue likely to draw the attention of Banking Committee Chairman Richard Shelby in Chair Yellen’s Senate Humphrey-Hawkins testimony next week. ***

*** And while in that testimony Chair Yellen is likely to avoid getting into the weeds of the March language debate — Capitol Hill is about the last place for nuance or new policy messaging — we do suspect that, if pressed, she will indeed affirm that June remains an option for the lift-off in rates. But she is likely to do so only within a careful context of charting a “data dependent” path that, even though looking “solid” and self sustaining, will be framed by the need for firmer evidence low core inflation will rise, however slowly, back towards its 2% target as expected. ***

*** The June option, we think, is meant more as a marker the start to policy normalization is nearing and to prod the market further off its dovish pricing, rather than anything more than a probability within the “mid 2015” window for a first rate hike. June, in other words, is when the FOMC is more likely to make its decision on the lift-off timing rather than when it actually pulls the trigger on that long-awaited first rate hike. Indeed, we still see a more prudent building of consensus in the Committee from June into September as the most likely meeting for a rates lift-off (SGH 1/7/15, “Fed: Two out of Three Ain’t Bad”). ***

*** All of that, however, is likely to be drowned in the message that a rate hike is, indeed, on the near term horizon, and in the testimony itself in the bulk of questions and media coverage focused on the “Audit the Fed” legislation and other proposed bills aimed at greater “oversight” of the central bank. Chair Yellen, for her part, may accent the Fed’s concerns over further efforts to restrict its crisis management powers as much as she presents a robust defense against the Audit’s intrusions into monetary policy. ***

Key Takeaways from the Minutes

We expect a key takeaway from the Minutes this afternoon will be the majority Committee’s surprisingly robust confidence in the base case for a “solid” recovery and a fast-approaching “start to policy normalization.”

But there are three other threads in the Minutes to look for in stitching together the backcloth to Chair Yellen’s testimony, as well as in coloring the Committee consensus going into its March meeting.

One is the debate we expect to see to some extent over the merits of dropping or tweaking the patience language to keep June as an option on the table for a first rate hike, whatever its probabilities may be. As important is how that discussion is likely to have been in the context of a broader debate over the role and function of forward guidance in the upcoming early stages of policy normalization.

While forward policy guidance was meant as one of two key policy tools at the Zero Lower Bound along with Large Scale Asset Purchases, some Committee members are arguing for an exit away from its current explicit phrasing, and certainly anything calendar-specific like a two-meeting patience, much in the way QE was phased out in the taper.

Others, however, and we suspect the dominant majority, still see the need for the forward guidance to stay in place, for additional clarity of the Fed’s intentions to provide a stability against market volatility when the central bank is still in such uncharted territory of the earliest phase of policy normalization. But if anything else, the debate over the evolution of the guidance underscores the momentum towards a change in the patience language in March.

A second theme we will also be looking closely for is the likely debate around the annual “Statement on Longer Run Strategy and Monetary Policy” on two fronts. First, how the Committee should adapt the longer run principles to reflect the risks in a persistent undershooting of the Fed’s three year old 2% inflation target, and second, how much weight to put on financial stability in the near term policy path and in the balance between the Fed’s dual mandate.

The bar is high for changes to the annual statement, as stated in the Minutes of one of the Committee meetings late last year, and we expect the Committee to reject putting a time frame on how soon it should bring inflation up to its 2% medium term target. Whether to put a greater accent on the risks of undershooting the target as well as overshooting is a closer call, but the Committee seems likely to reject that proposal as well.

At the same time, a parallel discussion may have also made it to the Committee table in January over whether to insert some mention of maintaining financial stability in pursuit of the Fed’s dual mandate. Again, we expect the arguments for such a change to the longer run statement itself to be rejected, but the inclusion of the debate on both issues in the Minutes could be taken as dovish on the latter just as the outcome to the inflation debate could be taken as hawkish.

And finally, one reason we still see rates lift-off on the near term horizon but likely slipping into September may become more apparent in a likely discussion in the Minutes over how the FOMC is interpreting the divergence between its base case on the near term policy path and the market’s far more dovish pricing across the curve.

For now, the forecasting assumptions is for the steady gains in employment to slowly underpin an upward pressure on wages as the last leg of the labor market’s healing since the depth of the recession, and in turn, that it will pull an admittedly very sticky core inflation back towards its 2% target once the downward pressure of the lower oil prices washes through the second round effects in the economy. The Phillips Curve, however flattened, is still lurking somewhere in the data.

Concerns over the signals in the global decline in yields or the risk of persistently low inflation becoming embedded in falling inflation expectations seems to be a minority but strongly felt view, and it is likely to be pushed to the back of the policy agenda for now.

But at the same time it is also likely to put caution in the step of the Committee towards the long awaited lift-off from the Zero Lower Bound, and certainly in the most likely pace of the tightening that follows.

A HHT Focus on the Audit

The thrust of Chair Yellen’s testimony to Congress will highlight how the momentum to the recovery is significantly stronger than the false dawns of previous years, in part, because healthier consumer and bank balance sheets means a smoother and faster transmission of the Fed’s highly accommodative monetary stance into real economy activity — and which she may add, has also been boosted by the absence of the fiscal drag of previous years, indeed, even a recent modest tailwind.

That, in turn, is the foundation to the base case being mapped out for that “solid” looking recovery and the fast approaching “start to policy normalization.” If Chair Yellen’s intended balance in her testimony works well, her Republican inquisitors will no doubt hear how the Fed is quite keen to get moving off the Zero Lower Bound, while her Democratic audience will most take away her cautionary tale that the balance of risks and costs to correcting a premature move points to prudence.

But in any case, any such balance or messaging for the markets or confidence in the outlook for the broader public in the testimonies before the Senate and the House Financial Services Committee is all more likely than not to become lost in part amid what may prove to be sharply worded questioning of the Fed’s “lax” supervision of the big financial institutions, its abuse of its monetary powers and, of course, the “Audit the Fed” legislation and other proposed bills aimed at greater “oversight” of the central bank.

As we wrote several weeks ago forewarning how an Audit political groundswell was building (SGH 2/5/15, “Fed: A Rising “Audit” Risk”), the powerful Senate Banking Committee Chairman Shelby has lent some credibility to  Republican Senator Rand Paul’s until now mostly ignored “Federal Transparency Act of 2015” in his stated intention to schedule hearings on it merits, though Shelby did shy away from endorsing the bill “as written.”

We in fact suspect neither Shelby nor the Republican Senate and House leadership will allow the bill — in particular, its clauses revoking the restrictions on the General Accounting Office from probing into monetary policy decision making in its current annual audits of the Fed — to make much headway towards floor votes. And in any case, it can be, and would be, vetoed by President Obama.

But its impact will be felt long before then, and much will depend on how the powerful Banking Committee Chairman Shelby uses the threat of the bill as leverage with the Fed and the White House on what he wants elsewhere, most probably further regulatory weight applied to the too big to fail banks or exemptions from Dodd-Frank for the regional and community banks. But on this point we are only still guessing, as Shelby will likely reveal his intentions only through the course of Committee hearings rather than in the broader Humphrey Hawkins testimony next week.

Yellen’s Robust Defense

Chair Yellen, for her part, can be expected to present a robust defense against the Audit’s intrusions into monetary policy, though for our two cents, she will need to go beyond warnings the Fed is already audited or the threat to the central bank independence since, frankly, the Audit supporters want to take away at least some of that independence. She will have to go further and more extensively into the reasoning behind the Fed’s stretched monetary policy mandate at the height of steering the free-falling US financial system through the 2008 crisis, or how and why the balance rose to more than $4.5 trillion.

And finally, beyond the now very public battle over the Audit bill itself, Fed Governor Jerome Powell cited a growing concern inside the Fed in his speech last week opening the Fed’s rebuttal of the Audit when he somewhat obliquely referred to “discussions about imposing new limitations on the Fed’s long held powers to provide liquidity during a financial crisis.”

This dials back to Dodd-Frank’s rewrite of the Section 13-3 powers in the wake of the intense debates in 2010 and 2011 over “bailouts” and the political uproar over the Fed’s alleged intrusion into fiscal policy (see SGH 10/21/11, “Fed: Europe and the new 13-3 Constraints”), and to date, those limitations have been untested in another crisis requiring abundant liquidity or individual institutions seeking access to the discount window despite the stigmatic new disclosure requirements under Dodd-Frank.

It is unclear where Congress may be going on this front, as no bill addressing 13-3 has yet to emerge in either the House or the Senate, but we will be watching for questions along these lines next week, as those limitations could quickly be thrust to the front burner depending on how smoothly or not the markets and the Emerging Markets take to a tightening of US monetary policy and the lessening of dollar liquidity.

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