Fed: The Shifting Debate

Published on November 12, 2015

The Federal Open Market Committee’s “at its next meeting” dollop of forward guidance in its October meeting statement may have gotten things moving, but it was last Friday’s stellar Non-Farm Payrolls print that did the heavy lifting in bringing market pricing for a first rate hike nearly in line with the Federal Reserve’s own expectations.

If things go smoothly, by the end of the trifecta of Chair Janet Yellen’s December 2 speech before the Economic Club of Washington, her testimony the next day before the Joint Economic Committee, and the November NFP release that Friday, there shouldn’t be any doubts over the FOMC’s intentions at its December 15-16 meeting.

*** The FOMC consensus has firmed solidly towards what was already a strong tilt towards a first rate hike in December (SGH 10/28/15, “Fed: A Hawkish Tilt”), and with it, a fairly high tolerance for an expected near term market volatility and a renewed dollar appreciation. Barring a low probability global negative shock or sharp reversal in the economy’s momentum, a near certain increase in the target range for the federal funds rate to 25-50 basis points will mark the end of seven long years of unconventional policy measures at the Zero Lower Bound. ***

*** The FOMC policy debate is already shifting to the pace of the rate trajectory, more specifically the phrasing in the December statement. Dovish Committee members, on their back foot and sensitive to the more hawkish rotation among the voting members next year, will be pressing for more explicit statement language on a likely “gradual” pace in removing monetary accommodation, while hawkish members are likely to resist such further forward guidance for fear it could limit the FOMC’s ability to respond to stronger than expected data without damaging credibility. ***

*** It is our sense the FOMC will only need to see continued cumulative gains in jobs rather than firmer evidence of higher inflation before undertaking the pace-defining second rate hike, whose timing is likely to be driven as much by the assessment of the market’s adjustment to higher rates and a caution against moving too far ahead of the effective equilibrium real interest rate than the data per se. But moving “sooner” in December is meant to ensure the flexibility to adjust the pace of rate increases, against either the upside of a faster than expected rise in core inflation or a downside headwind such as an accelerated dollar appreciation. ***

The Market’s Adjustment

It is not all that hard to see just how much of a game changer the October NFP was in driving the market pricing on the timing to the Fed’s long awaited first rate hike.

Fed funds pricing was barely 34% or so prior to the October statement, rising to roughly 50% before the jobs number and got to just the other side of 70% yesterday. With so much of the market still skeptical the Fed will manage more than a rate hike or two, the 2016 year-end pricing is still well under the FOMC’s median dot projection of four rate hikes next year, but even then the market pricing for the December 2016 fed funds rate is rising, to around 85 bp at present or three rate hikes, from where it was before the October statement, at around 60 basis points, or two rate hikes.

All the certainty in a single jobs data point like October’s NFP could, of course, still reverse just as easily and quickly in the next NFP in the first week of December as October’s upbeat numbers reversed September’s gloomy picture. But the market pricing is clearly moving in the direction the Fed believes is supportive of – or resigned to, take your pick – a first rate hike in mid-December.

And for all that, the data like the NFP doesn’t really move the policy needle for the Fed all that much as it stokes a change in market psychology and expectations, which in this case, is clearing the runway for a rates lift-off.

For a FOMC majority, a carefully crafted consensus being constructed since March by Chair Janet Yellen around a “sooner” start to policy normalization in return for a likely gradual pace has been in place since summer, with a first rate hike as soon as the September meeting.

Fed officials were painfully aware they lost some of their messaging credibility in September’s “close call” caution to hold off on a first strike for a prudent assessment of the new tail risks from abroad. But through the turbulent period of a fraying consensus in the wake of the September meeting, an unexpectedly weak September NFP, and a loud but brief Board rebellion (SGH 10/14/15, “Fed: Houston, We Have a Problem”) the Committee majority’s confidence in the economy’s forward momentum never really ebbed.

Indeed, we suspect in fact that the October meeting Minutes, when they are released on November 18, may again display last-ditch dovish arguments against a December rate move, but in an echo of the July meeting Minutes, are likely to show a voting member resolve still tilting to a rate move before year-end. The decisions to delete the reference to international risks, which we had thought was likely (SGH 10/26/15, “Fed: Halloween Reset”), and more importantly, to include the explicit reference to a decision “at its next meeting” were meant to shake the complacency out that had settled back into market pricing.

The October NFP last week, in that sense, was a Godsend to the Fed in further prodding the market pricing and, hopefully, the sort of portfolio adjustments that should keep market dislocations to a minimum by the time a likely first rate hike is announced the afternoon of December 16.

A first rate hike, the Fed thinking goes, will likewise force the market to take the data much more seriously through next year, looking at how it may underpin further rate hikes rather than the assumption that has long prevailed that a dovish Fed under a dovish Chair will be looking for every possible reason to avoid rate hikes. A rate hike, even one as small as perhaps an effective 15 to 20 basis points should still be enough to force market traders and investors to factor in rising financing costs to their carry trades, and a new volatility in term premiums and credit spreads. That, in turn, should translate into leverage steadily being eased out of the market’s positions.

The key, though, to limiting at least some volatility that is nevertheless almost certain to greet the reality of the first rate hike since the end of the last tightening cycle in 2006 will be in the credibility with which the Fed can make the case for how gradual the pace of rate hikes are likely to be after that first move. In particular, the second rate hike will be just as or even more important than the first in signaling that likely pace.

Defining Gradual

While the FOMC consensus for a December start to policy normalization may have been solidifying in recent weeks, there is almost no consensus yet on what exactly a “gradual” rate trajectory actually translates into or what conditions the Committee will need to see to warrant a pace-defining second rate hike. That debate will only begin in December and it may extend across several meetings.

For now, the pace and end point to the most likely rate trajectory is being signaled in two ways. The first is through the sentence included in every FOMC statement since March 2014 that even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”

The other of course is the rate dot matrix of the Summary of Economic Projections that are updated every quarter. The “blue dot rate plot” is, however, at best a visual representation of the range of rate paths built into the staff forecasts, in effect telling the markets how optimistic or gloomy the growth projections are and the expected degree of policy firmness assumed to hit the forecast. But they are not necessarily built or intended as forward guidance.

Fed officials, of course, have been stressing how gradual the rate trajectory is likely to be in their public remarks and speeches through all of this year. But in the Fed lexicon, it is one thing to repeat the policy messaging endlessly in speeches, it is another to formally affirm it in the statement language.

So many Committee members, especially the more dovish, are going to be pressing to include a more explicit forward guidance in the statement affirming a likely gradual pace in the removal of monetary accommodation, at least through next year.

Dovish Committee members, for instance, are fearful the equilibrium real interest rate is barely positive if not still negative, and remain wary of an extended downward global pressure on US inflation. With their assumptions for the longer run unemployment rate, or NAIRU, tending to be lower than the median of the Committee, say more like 4.6% to 4.8%, it means their forecasts for the core inflation measures are unlikely to be anywhere near mandate-consistent level much before late 2017 or 2018. They therefore want to see clearer and cleaner evidence of upward wage pressures on inflation before putting their faith in the base case forecasts or in Phillip Curve linkages; trust but verify, in other words.

The more hawkish members of the Committee, perhaps feeling emboldened by the last NFP print and other data that would seem to testify to their expectations of a pickup in growth and inflation through next year, will argue that going any further in messaging the expected trajectory of hikes beyond the existing ‘below normal” sentence could potentially limit the Fed’s flexibility to respond to any stronger than expected data.

And in any case, they will no doubt add, wasn’t the idea since March this year to move away from forward guidance as a relic of the very unconventional policy the central bank is exiting from, it’s inclusion in the October statement notwithstanding?

Supportive Data to a Gradual Pace

However the gradual guidance debate plays out in next month’s meeting, we for now suspect the Committee will come out leaning more towards the “dovish hike” that was on the table in September, with the actual phrasing in the statement still to be decided, probably at the meeting itself.

And while we likewise believe the Committee will not go so far as delaying a second rate hike until the “white of the eyes” in actual upward inflation, we do think the dovish concerns over the risk of a policy error in moving ahead of the effective equilibrium interest rate will nevertheless be considered closely in the approach to the timing on that second rate hike, data permitting.

The Fed, after all, is only undertaking a first rate hike when it is confident the economy is strong enough to absorb a second or third hike, but that does not necessarily mean it won’t be weighing those subsequent hikes just as cautiously and prudently as they did the first.

To be sure, that pace will, of course, ultimately depend on the data and how fast or slow it is indicating the economy is going. But for now, the Committee majority seems confident the data after the turn of the year will be supportive of their intention to go as gradually as necessary in its approach to the second rate hike and through at least next year in slowly removing monetary accommodation.

When looking at the downside risks, for instance, the Fed is for now finding few reasonable arguments that the momentum in the economy’s growth is going to falter or slip back into a subpar growth, much less a recession: job creation is expected to slow from its heady October pace, but to still provide a steady underpinning to demand, while the Fed’s international forecasts see only a modest slowdown, as opposed to a harder landing, in Chinese growth next year (which we too have written, see for instance (SGH 10/13/15, “China: Breaking Below the 7% GDP Target”) and for at minimum a stabilization if not slight uptick in European growth.

And to the upside, our sense is that the Fed does not expect the out-sized 2.5% annualized jump in October’s Average Hourly Earnings to be a harbinger of faster than expected wage growth. Much of the surprise in the faster wage growth was due to rounding up than an underlying upward pressure on wages that could drive core inflation higher.

And it is our sense the appreciation of the dollar may play a major role, just not in the way many expect. The renewed appreciation in the dollar on the back of rising expectations for a December Fed hike and an ECB increasingly expected to embark on a second leg expansion of QE and negative rates is certainly a headwind to the desired rise in US core inflation. But dollar strength will not be precluding the first rate hike, it will rather help offset any stronger than expected rise in domestic wage pressures, and with it temper the pace of subsequent hikes (SGH 11/6/15, “Fed: Protecting the Pace”).

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