With no rate hike looming in the Federal Open Market Committee’s statement this Wednesday, attention is largely focused on whether the FOMC will offer any confirmation of the market anxieties since the turn of the year over China and faltering global growth and whether the Committee will signal rate intentions that would validate the market’s near-recession pricing.
*** The FOMC, we believe, will steer clear of offering too much on either count. We expect the statement’s descriptive first paragraph on the economy to read dovish, just not that dovish. There is, for instance, likely to be an echo of the September statement in again noting the potential restraints of renewed international and financial developments, but strong job creation and labor market slack that continues to diminish should allow them to still describe the risks to growth and jobs as balanced. Persistent low inflation and especially ebbing inflation expectations do remain primary policy drivers, but we think the Committee will be hesitant to add to the close monitoring language already in the December statement. ***
*** That said, while it is too early for an FOMC consensus to be forming — Chair Janet Yellen’s February 10 testimony on Capitol Hill will probably offer the earliest sense of that — we do think the case inside the Committee for a March rate hike is dimming. The renewed dollar strength and oil price weakness, even if both are to stabilize in coming weeks, are probably already enough to push a rate hike back, as even the Committee’s more hawkish members are unlikely to see “conforming” forecast data, much less the “confirming” actual inflation data the doves seek by then (SGH 1/8/16, “Fed: Confirming and Conforming”). And the longer the low inflation persists, the more the Committee focus will be on any further erosion in inflation expectations, giving the Committee further pause. ***
*** In other words, we think the FOMC will aim for an underlying tone of caution-flavored optimism on the outlook, avoiding any sense of elevated concerns that could validate market anxieties, both in the statement and the post-meeting communications. The Fed for now simply does not see anything like a recession or even a stall speed to the US recovery on the horizon, nor is it likely to pivot away from its slack-based assumptions of slowly rising core inflation, presumably later this year. But the near term persistence in low inflation and a wary eye for Emerging Market fragilities will make the FOMC more than willing to slow the pace, and number, of rate hikes this year as needed. ***
“Debris in the Rearview Mirror”
When spreads in the high yield market began to widen late last year, Fed officials generally saw it as a net positive that, along with moderate declines in equity prices, was burning off some of market excesses after the years of unconventional monetary policy. And as we noted in previous reports (see SGH 8/27/15, “Fed: Cautiously Repositioning”), the Fed has long expected to see “some debris in the rearview mirror” after a first rate hike as markets began adjusting positions and valuations to the end of zero rates.
Well maybe not this much debris, but in any case, while the central bank will certainly be monitoring the markets for signs of stress, the Fed’s response in the statement or in the public remarks soon after are likely to be limited, for the most part with the central bank taking the price-gapping gyrations in stride.
The reason is primarily because the Fed doesn’t see pressing evidence of an unexpectedly sharp slowdown in the real economy lurking behind the market’s volatility. For all the chatter on CNBC about rapidly unraveling global growth reaching US shores, the Fed just doesn’t see a recession looming on the horizon.
On the international front, China is certainly slowing as it maps out its enormous policy shift from investment-led to domestic-demand driven growth, but the Fed forecasts already has built in slower China growth and is putting a low probability on a Chinese hard landing. In a similar vein, the Fed base case is for a modest upturn in European growth, and for Japan to hold its own.
And with a far less dire take on the international outlook this year, it is hard for the Fed to find how global risks could seriously undercut its forecast for a modestly decent — well, relative to a low trend growth anyway — domestically-driven 2.4% growth this year, even if staff tweak down growth this year slightly.
The steady domestic demand generated in job creation expected to average around 150,000 jobs a month, slightly higher real wages in the absence of inflation (despite the lackluster growth in wages and average hourly earnings), and a decent tailwind to fiscal policy (SGH 10/26/15, “Capitol Hill: Two Year Budget Deal”) are more than enough of an offset to whatever weakness is imported from abroad.
And while the dramatic collapse in oil prices have ravaged the US energy sector, lower gasoline and energy prices are still a net positive to US growth; the bump up in expected consumer spending on the back of those lower gasoline costs just has to pick up soon.
Perhaps one, under-appreciated downside risk to this domestic growth scenario is a potential confidence shock to demand in what promises to be a wildly unpredictable US election year finally getting underway next two weeks in the Iowa caucuses and New Hampshire primary the week after.
Ebbing Odds for a March Hike
Our sense, though, is that as crazy as this US election year could get, the FOMC is for now paying far more attention to the persistence in low inflation and ebbing inflation expectations, now that the base effects of a fading strong dollar and weak oil prices seem unlikely to be dropping out of the data as soon as was expected (see SGH 12/16/15, “Fed: A Confident Start to Policy Normalization”).
The Committee already put a major accent on its close monitoring of inflation and inflation expectations in the December statement, making it somewhat unlikely they will feel the need to double down on the point. But it will be interesting to see whether the FOMC feels the need to tweak in any way the treatment of the inflation mandate in the annual “Statement on Longer-Run Goals and Monetary Policy Strategy” that will be reviewed in the January meeting. We doubt it, but could see a debate showing up in the Minutes.
In addition to its ongoing eye on inflation dynamics, it is our sense that the Fed is also paying considerable attention on any signs of fragilities in the Emerging Market Countries, and whether the pace of its intended policy normalization calibrated to the trade-offs in the US economy may prove too much abroad.
Taken together, even if the growth forecast is trimmed only slightly in the staff preparations for this week’s meeting or the markets quickly stabilize, we suspect the burden of proof is already swinging hard against the base case of four rate hikes this year.
That goes somewhat against the better probabilities we saw coming out of the December meeting, but even the more hawkish Committee members may have to squint hard to find “conforming” data in the small print of the inflation data points that they could argue was in line with the evolution of the forecasts for rising core inflation through the year.
In other words, the persistence in the low inflation in itself would not preclude a rate increase, but the longer the delay in the dollar and oil base effects, the more risk there is in a further downward drift in survey and market inflation expectations that would indeed give the Committee pause. So while it is too early to assert much in the way of a Committee consensus on the timing to a second rate hike, March is certainly looking problematic.
But we do not think the FOMC would have any problems with a pass on a March rate hike, per se, and a solid Committee majority certainly do not think the start to policy normalization in December was a policy error. The “sooner” start was meant to maximize the central bank’s policy flexibility to slow or speed its pace of rates hikes around that base case of four rates hikes this year.
If March comes and goes without the second rate hike, there would also be something of a win-win in it. It might take the edge off the dollar’s upward trajectory that is already tightening financial conditions to some extent, and in doing so, it would ease some of the policy divergence between the Fed and the other main central banks and temper some of the exchange rate disinflationary impulses.
But perhaps the broader point is that a Committee majority still envisions a strategically-driven “sooner and slower” upward rate trajectory, even if they agree to the tactical need to stretch out its pace; nor is there any stepping back from the slack-based assumptions of slowing rising domestically-driven services sector inflation, however much the Phillips Curve may be questioned.
What after all, in the scheme of things over a three year rate tightening horizon, is a few months of an extended pause at this early stage of policy normalization?