Sometimes pitching policy as “data dependent” can prove to be awkward for the Federal Reserve when the data sharply turns against expectations and the base case policy path being laid out. And that is certainly the case in the aftermath of Friday’s dismal Non-Farm Payrolls numbers.
*** It goes without saying the Federal Open Market Committee isn’t going to be hiking rates at its October meeting, though then again, it was a low probability anyway. But despite the pessimistic NFP aftershocks, and assuming the upcoming data goes their way with growth still above trend, the Committee majority, albeit with the internal burden of proof starting to swing against them, still see the Fed pressing ahead with the base case for a first rate hike at their December meeting. ***
*** Fed messaging will increasingly stress that last week’s NFP was but one number that should not detract from cumulative gains in the labor market, that the pace of job creation was expected to slow as unemployment reaches NAIRU and, perhaps more crucially, that policy will be highly accommodative even as normalization gets underway. A new narrative, that policy normalization is needed to temper risk taking excesses that could imperil financial stability, may also soon feature more prominently. ***
*** Despite its best efforts to present a uniform message, however, the internal Committee consensus does seem to be fraying. The Fed’s credibility will also be questioned by a deeply skeptical market confused over the Fed’s reaction function and the assumptions driving how the data is interpreted in such a “data-dependent policy path.” There may be conflicting messaging in the weeks ahead as well, putting pressure on Chair Yellen to step in again to put a marker down on the consensus near term policy outlook. ***
It was hard not to be shocked by the NFP, especially since its 142,000 jobs print for September was an especially large downside miss relative to widespread expectations around the 200,000 mark. Worse, most of the other categories seemed to tell the same story of slowing job creation and economic growth being pulled down by international developments.
And the shock of the Friday’s NFP was unmistakable. The dominant view across the fixed income markets is of a labor market downshifting hard since summer, far from last year’s 260,000 pace of job creation, and which is being taken as confirmation of the more pessimistic narrative of slowing global growth and dis-inflationary headwinds that are already reaching into the US economy via the most vulnerable sectors like manufacturing and energy.
And coming so quickly after the Fed’s cautious hesitation to hold off on a first rate hike at its September meeting – in which the worrisome international outlook was the only “new” information – the NFP is quickly reinforcing an already prevalent market skepticism of an impending rate hike, and indeed, that the Fed will always find a reason for delay.
The markets have essentially pushed any chance of a first rate hike to March next year, and perhaps more tellingly, a second rate hike coming in late 2016 at best or early 2017. In contrast, 13 of the 17 FOMC members have a first rate hike by year-end, and their September projections have the fed funds rate at its longer run neutral levels of 3.5% by 2018.
The Fed, needless to say, has a major messaging challenge in the next few weeks in the run up to its end-of-October meeting.
The Fed has in some sense been thrown on its back heel, scrambling now to push forward to at least keep December live even if an October pass is a foregone conclusion by getting a messaging reset underway.
And that, in turn, will not only depend on whether the data cooperates through the next two months, but more importantly, how effective the Fed will be in clarifying how the data is interpreted so the Fed’s reaction function can be better understood. In some sense, there are two competing underlying paradigms or conceptual frameworks.
In the market pricing, there seems to be dominant, gloomier reaction to data points. It may to some extent be a reflection of just how long many bond portfolios are, or the skepticism born in repeated losses in the Fed seemingly “blinking” on a more hawkish stance at every key turn. But the market sentiment also looks to be fully embracing the “secular stagnation” assumptions of a deep demand shortfall that is keeping the equilibrium rate negative, and that a slowing global growth and commodities-led deflationary impulse will or is already weighing on US growth and flattened price pressures.
The Fed’s competing narrative is of a New Keynesian, non-linear, expectations-augmented Phillips Curve: the more fundamental driver to the outlook is a tightening labor market and rising consumer-led demand at home that will in time more than offset the international effects that will fade from the data and, in time, be lifting core inflation.
It is non-linear in that as the persistent post-crisis “headwinds” dissipate, with balance sheets being repaired, credit access picking up, steadily rising demand leading to higher business investment and productivity gains, monetary transmission channels will become increasing unclogged and the massive accommodation at present will need to be steadily and slowly removed with rates being normalized as the economy itself is finally “normalizing.”
And it is “expectations augmented” in that still stable (and more reliable) survey-based measures of inflation expectations should prevent broader inflation expectations from falling persistently, which will allow the Fed a more steady policy path that will eventually bring inflation back to its mandate-consistent levels with only a minimum of a possible overshoot of its 2% medium term target.
But they are, in effect, two sharply contrasting paradigms, so the interpreting of the data in real time is not just about indicating whether the economy is softening or holding steady and gaining ground, but which of the competing conceptual frameworks best describes the underlying economic trends.
Chair Yellen laid out very forcefully the case for the Fed’s mostly slack-based framework guiding its assumptions and the policy path forward in two landmark speeches, in San Francisco last March (SGH 3/27/15, “Fed: The Emerging Policy Path”), and in Amherst a week after the September FOMC meeting (SGH 9/24/15, “Fed: Yellen on Inflation”).
And assuming the data do indeed show an economy still expanding above trend – always an important caveat – we expect most of her colleagues to build on a Fed message reset that will reinforce the base case path she mapped out over the coming weeks and months, perhaps culminating with another speech by Chair Yellen already on the calendar before the Washington Press Club in early December.
The Messaging Reset
So caught on their back foot by the dismal NFP and the signs of slowing growth, we expect a majority of the FOMC to press the case for staying the course on a start to policy normalization before year-end on essentially four themes.
First, there has been so much “cumulative” progress in the healing of the labor market – some 60 consecutive months of job growth is hard to ignore – driven by the highly accommodative, lower for longer policy to date that it has pushed the headline unemployment rate to or through the assumed NAIRU. Yes, the market should look to the coming data in a data-driven policy path, but that must always be framed by the cumulative gains over time as well, Fed officials would or will say.
Second, and closely related to that, the pace of job gains was supposed to slow, and that slower pace of job growth is already baked into the Fed forecasts, judging by the September Summary of Economic Projections that put the headline unemployment rate at only 4.8% by the end of 2016.
Almost by definition, that pace needs to slow, as the labor market is driven to NAIRU, it becomes harder to find workers or at prevailing wage levels. Instead the demand for labor reaches into the outer corners of the market, offering the part time full time work, or seeking out the discouraged or longer term unemployed, often with higher wages.
And while the headline number was a rather dramatic drop in a single month, many Fed officials will point to the downward revisions in the preceding months as indicating the long expected tightening in the labor market is already underway, indicating that NAIRU is north rather than south of the 5%.
What’s more, the weakness in the jobs market is still mostly confined to the spillover from global factors rather than being homegrown, which the Fed is likely to underscore as pointing to the economy’s underlying resilience.
Fed officials may also increasingly press a third argument that rates need to be moved off zero out of concerns for financial stability: with a zero policy rate, the price discovery process is limited and the central function of finance, to channel savings to investments, is impaired with rising mal-investment. A prolonged stay at the Zero Lower Bound, in other words, breeds financial excesses, particularly in the reach for yield, and ultimately, the seeds of a boom that can only lead to an even more severe bust.
And finally, many FOMC members will also be fleshing out the longstanding message on a “gradual” pace of policy normalization, stressing how highly accommodative policy will be in the long trek from zero rates to the assumed longer run 3.5% longer run neutral rate.
Policy normalization, in other words, would not so much be a “tightening” in the traditional sense as much as it is an almost “technical” adjustment to move off the crisis-driven Zero Lower Bound in line with the steady progress in the recovery and to better align the policy rate to what is believed to be a just positive and ever so slowly rising effective equilibrium real interest rate.
Better Framing Expectations
All of this is to say that a December rate hike is not at all off the table. It is however our sense the earlier consensus for a rate hike before year-end is fraying to some degree and we do think the burden of proof within the Committee is shifting somewhat against those making that case and back to those favoring a 2016 first rate hike.
And the Fed policy messaging consistency and clarity has admittedly been less than stellar; well, you live, you learn.
But depending on how the data play out in the coming months and if the Fed can manage to frame the expectations and interpretation of those data releases, a majority of the FOMC is still betting the case for hiking may be enhanced, not eroded, in the coming months.