Fed: There Will Be Blood

Published on August 24, 2015

It would hardly be an understatement to say Federal Reserve officials will be keenly watching the worldwide market rout as closely as just about everyone else. The policy response will depend obviously on how long the sell-off lasts, if there are any accidents along the way, and most importantly, to what extent its effects are likely to spill over into the real economy growth and inflation. But the markets are anxious to hear from Fed officials now, not the September meeting, which is a life time away.

*** The policy messaging this week — first up is Federal Reserve Bank of Atlanta President Dennis Lockhart later today and Federal Reserve Bank of New York Fed President William Dudley Wednesday morning — is going to be tricky. We expect both to acknowledge Fed concerns but to assert that some re-pricing and higher term premiums were expected, and that Fed policy will not be directly driven by market volatility. That said, any mention of possible downward revisions to near term growth would signal further erosion in the previously building Committee consensus for a September first rate hike.  ***

*** While the market volatility does not preclude a first rate hike in September — the meeting is still more than three weeks away — our sense is that it is nevertheless shifting the burden of proof within the Committee back on those who making the case that the near term data and forecasts warrants a “sooner” first rate hike. That argument, to maximize a prized policy flexibility to go as gradually as deemed necessary on the pace of subsequent rate hikes, may get a further testing in the debates over inflation dynamics at the Jackson Hole conference this weekend. ***

*** Nevertheless, the desire to start “policy normalization” remains strong, and once the market stabilizes and if the real economy looks relatively unscathed — the August Non-Farm Payrolls print on September 4 could have an out-sized impact — that first rate hike will still be on the table. But time is running short for enough of a Committee consensus to message rate intentions, and we suspect (with limited certainty) the FOMC could opt to use September to prepare a “longer runway” to a rates lift-off later this year in an echo of the three month delay to the taper in 2013. ***

Volatility and Higher Term Premiums Expected

Numerous Fed officials, including Dudley and Chair Janet Yellen herself, have been warning for some time that they expect some re-pricing and volatility in the run up to, and in response to, the reality of a first hike. But while expected, and even desirable for some of the excesses to be shaken out of the system and a long repressed term premium to be rising, those forewarnings were always offered with an unspoken caveat it happening so swiftly it threatens systemic instability would be another matter altogether; indeed, avoiding a market dislocation stands at the very heart of the gradual rate trajectory.

In that context, it goes without saying the FOMC would be extremely reluctant to raise rates amid such market volatility for the straightforward reason that when the financial markets are in such disarray and dislocation, the transmission mechanism is not functioning, and a policy change could make it even worse.

But the next FOMC meeting is still more than three weeks away, not this week, and Fed officials are waiting to see where markets stabilize, perhaps at more sustainable levels with less excessive valuations — and with minimal damage to the real economy.

So importantly, the Fed staff will need time to incorporate the new market pricing and financial conditions into new forecasting simulations. In particular, they will try to incorporate how much an erosion there is likely to be in consumer and business confidence and spending and, in turn, how much that may alter the estimates of aggregate demand and the central tendency growth projections being prepared for the September meeting.

In more “normal” conditions, the gains to disposable income from much lower gasoline and energy costs would have translated into higher household spending, while the stock market gains and better housing prices likewise translated into stronger household balance sheets, adding to a virtuous cycle of rising confidence, rising spending, and rising business investment to chase that demand. The Fed may now need to hit the delete button on many of those assumptions and start all over.

The Fed earlier this year had overstated the likely boost to consumption from last year’s plunge in oil prices, as consumers tended to bank at least half their gains in higher savings, distrusting how long the lower gasoline prices would be. That reluctance looked to have been starting to give way, and the Fed was for the most part penciling in the more recent dip in oil prices would be to an ever greater degree reinforcing a sense of confidence among households they were free to spend as the lower gasoline and energy costs were here to stay.

But the Fed staff have never been quite sure how to incorporate into their forecasting models the still enormous psychological overhang from the ravages of the 2008-2009 global collapse in demand and job losses, and it will take some time to assess and potentially factor in a lingering hesitation by consumers and business alike to spend or invest so freely.

And add to that the ominous signs Capitol Hill will return to its dysfunction with polarized party infighting over the 2016 fiscal budget and the debt ceiling through the rest of this year, perhaps adding to falling confidence.

Taking the confluence of these scenarios together at this critical point in the run up to such a pivotal FOMC meeting, it is more likely than not pointing to another round of modest downward revisions to growth in the September Summary of Economic Projections. That could also be coming on top of modest but likely revisions to the earlier assumptions that the effects of the strong dollar and lower oil prices would be fading from the inflation numbers by this time next year.

And that, in turn, may be pushing further away the FOMC’s desired “reasonable confidence” inflation will be turning back north towards mandate-consistent levels.

Fed Messaging from Lockhart to Jackson Hole

That prospect of less certainty on the growth outlook and a delayed rise in inflation will in our minds be the most important thing to watch for in any remarks to the press by Atlanta Fed President Lockhart today, which thankfully, if he does speak with reporters after his speech (which is on pension plans) would come after the close of the markets this afternoon.

Lockhart, of course, was the first out of the gate after the July meeting to make the case for the more hawkish view of what we still think was a thin Committee majority for a likely first rate hike in September.  To do his remarks justice, it has to be said he did caveat that with the assumption the economy will evolve in line with the Fed’s central tendency growth projections.

So if he makes any concessions those projections may now warrant some closer scrutiny, it would suggest a further blow to the increasingly fragile consensus on a September first rate hike that had been building within the Committee ever since last spring.

Probably carrying even more weight for the market will be the remarks made by New York Fed President Dudley, who showed up on the Fed speak calendar for a speech tomorrow morning. That, importantly, may provide some breathing space for policy messaging if the markets stabilize at least a little, however steep the falls prove to be.

While we suspect Dudley will be reluctant to signal much clarity on where the FOMC consensus is — and that in itself probably testifies to how uncertain they are at this point — our sense is of more FOMC members starting to waver on the merits of the “sooner” start to policy normalization to ensure maximum policy flexibility in order to go gradually and avoid the risk of needing to move rates rapidly if stronger wages and inflation do finally show up in the data.


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