Judging by the market pricing, you would think that the single most influential Federal Open Market Committee member is the most dovish of an already dovish FOMC, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota. Indeed, the market’s pricing for the Fed’s eventual rate tightening is even well under Kocherlakota’s probable “dot plot” running along the floor of the FOMC’s year-end fed funds projections.
The Fed’s forward policy guidance has for the most part been geared towards tempering a premature rise in yields, not to lift yields from below the Fed’s own dovish messaging, so in that sense, the uber-dovish market expectations has taken most of the FOMC by surprise.
After all, this is a highly accommodative Fed, but one that at the same time is growing more confident in the pace of the recovery despite first quarter softness. And that is likely to color much of what Chair Janet Yellen has to say in the post-meeting press conference next Wednesday.
Three themes, we believe, are likely to dominate next week and to thread through the Fed’s messaging across the summer months:
*** While several FOMC members have expressed concerns over market “complacency” — the new euphemism for financial stability angst — Yellen is likely to stress an FOMC majority’s belief the market still remains shy of yields and spreads so compressed that it warrants a change in the near term policy path. In any case, most of the FOMC think the market is likely to steadily align more to the Fed’s own rate path as the expected stronger data comes in and is perhaps nudged along by what is likely to be the Fed’s more upbeat messaging on the growth outlook. ***
*** The Fed in fact is showing every sign of staying the course on its growth narrative of a near 3% recovery that critically has only been delayed, but not derailed, by the softness of the first quarter. The June 2015 and 2016 “dot plots” are likely to replicate the March levels, with a modestly more hawkish look. Lift-off will remain in the second half of 2015 with a trajectory still likely to be gradual, and a lower neutral rate of not less than 3.5%. We expect Chair Yellen will go to some length in the presser to further explain the Fed’s “below normal” neutral rate reasoning. ***
*** The Exit will again be on the agenda of the June meeting, and several Committee members have already offered their ideas on the Exit. For now, there is an informal bookend of sorts to the FOMC consensus taking shape, to keep the focus at the front end on rates — meaning the end to reinvestments is more likely than not to be put off — and that asset sales are still at the back of the queue. But it remains early days on the revamp to the June 2011 Exit Principles, and we still think the unveiling of a new sequencing is unlikely before the September meeting. ***
Because the Fed’s forward policy guidance has been built around an assumption it would need to defend its lower for longer messaging against higher than desired yields, Fed officials were more or less flummoxed by the market’s aggressive rally that has brought its pricing for rate hikes well under the Fed’s own dovish rate “dot plot.”
Several FOMC members have expressed their concerns over the market’s complacency in such an aggressive pricing and low volatility, but for the most part, Fed officials were a bit unsure how to respond or indeed whether they should bother to; after all, by definition, the new “qualitative guidance” adopted at the March meeting was meant to mean less of a heavy hand in-close guidance that would allow the more natural volatility of a two way market and perhaps even provide information on the economy back to the central bank.
Much if not most of the low volatility is of the Fed’s own making, of course, and so it may be a bit rich to now bemoan the seeming complacency. And indeed, at the same time, it has not been lost on many FOMC members that the recent swoon in yields could go a long way to offsetting the damage done to the housing market in the wake of last spring’s taper tantrum.
As we noted previously (SGH 5/15/14, “Fed: Message Bifurcation”), the Fed was probing the markets to gauge what was behind the recent bond market rally, mostly concerned the market was sniffing out a faltering in the US economic growth. They have since concluded the sharp drop in yields was more technical than an indication of diminished growth expectations.
And judging that market pricing is still well north of the sort of compression in yields and spreads that became evident early last year, our sense is that the Fed is less inclined to aggressively push back against the market for now, though it also seems likely to avoid validating the dovish positioning under the Fed’s own highly accommodative stance.
If truth be told, there is no small asymmetry to the Fed’s reaction to a market pulling away from the its central tendency forecast and projected policy path: Fed officials tend to be far quicker to respond to a premature market tightening in financial conditions that threatens the recovery, but far less so when the market is taking an even more dovish positioning.
Thus a desire not to disrupt the unexpected stimulus – amid a tapering no less, who knew? – while at the same time carefully avoiding a validation of the pricing seems to be the Fed’s adopted rhetorical stance for now.
That, however, may neatly flip as the recovery reaches an escape velocity that the Fed is confident means a self-sustaining growth in less need of monetary policy support.
Delayed, not Derailed
And the Fed is indeed sticking to its script of an economy on a steady if still slow path towards a 3% recovery. The 2014 real GDP central tendency forecasts will probably be tweaked down again in the June Summary of Economic Projections to account for the softness of the first quarter — perhaps to a new range of 2.5% or 2.6% to 2.8% — but in 2015 the economy is still likely to show a “good enough” 3% plus growth. The Fed’s growth narrative was only delayed, not derailed.
Friday’s Nonfarm Payroll breakdown likewise offered the Fed every reassurance the economy is essentially on that path. Anything above a 200,000 a month net job creation and a moving average job creation in the same range is encouraging. A million net new jobs in the first four months of the year is nothing to dismiss.
And depending on how quickly the labor participation rate begins its expected pick up – all those underemployed, long term unemployed, and discouraged workers including those with criminal records no less are still to be drawn back into the labor force — the June SEPs may also mark down a faster projected fall in the 2014 headline unemployment rate from March’s 6.1%-6.3% to perhaps dip below 6%.
What’s more, the most recent annualized gains of 2.1% in wage growth — the barometer to how much of the unemployment is structural versus cyclical — is at least moving in the right direction even if still far too low to move the Fed’s policy accommodation needle just yet.
The same goes for inflation. While still under the 2% mandated inflation target, the most recent core PCE reading of 1.6% is also at least moving in the right direction, edging up from the 1.2% or less range earlier this year.
When it comes to the SEP rate dot plot to be unveiled with the June meeting statement, we suspect the faster fall in unemployment may move some staff and Committee members to tweak their blue dots up a bit, but the modest marking down in the pace of growth may lead others to nudge theirs down. Our sense is that the 2014 dots may become more dispersed, but essentially stay more or less in line with the March dots, albeit perhaps with a slightly more hawkish look to them.
Along those same lines, we think a continued upward rise in the rate projections can be expected for 2015, and perhaps more tellingly, when the 2017 dots are unveiled in September, a likely majority of the FOMC’s rate dots will be moving above 3% and higher.
The Fed’s assumed appropriate rate path, then, is still more dovish than a traditional Taylor Rule, but certainly more hawkish than a current market pricing that seems to have taken the March statement’s “below normal” neutral rate to heart and then some.
And while the burden of proof may now still be on those who would make the case for moving sooner, and the reaction function tilted to patience on both rising wages and inflation, we suspect the balance of views within the FOMC will be steadily moving towards a closer scrutiny of the cost-benefit trade-off in such a high level of accommodation as we get deeper into this year and the mandate-consistent trends level in unemployment and inflation come closer into sight.
Exit Premium on Flexibility
And that, in turn, also neatly brings the Exit discussions into context. It is hard to recall now, but when the FOMC hammered out the sequencing of the “Exit Principles” at the time of the June 2011 meeting, it did so because the Committee thought the moment of rate hikes were on the near horizon. It of course did not quite work out that way, and now, three plus years later, the need to raise rates is again within sight.
We doubt there has been any substantial progress made on the revamp to the Exit sequencing. In the near term, much of the Fed’s focus is on the testing of the various new policy tools to steer short term rates to tighten its control over the spreads between the various short rates, how they extend further out the curve, and of course, to get a sense of the sensitivity of their transmission to the real economy. The rate trajectory is likely to be gradual, if for any other reason, because no one including the Fed is quite sure how exactly this will all play out.
The more immediate and more pressing issue in the months ahead is how to and whether the Desk can distinguish a formal “policy” tightening from an “operational” tightening in the eyes of the market when the Desk at some point lifts the rate for the overnight reverse repo facility above the effective fed funds rate, or to gauge how the Federal Home Loan Banks would react to an afternoon setting of the ON RR rate from the morning.
Perhaps for all of these reasons, there seems to be a growing consensus at this early stage to keep the focus in the initial phase of the Exit on rates as the primary tool to tighten financial conditions. Why complicate an already complicated tightening process by dragging in an end to the reinvestments and putting duration back into the market? So with that in mind, it is almost certain to mean the end to the reinvestments is going to be pushed back until after the rate hikes are underway, with the decision on when exactly to end the reinvestments probably held off until after the FOMC sees the effects of the early rate hikes.
In any case, the Fed is growing much more confident in its ability to manage the enlarged $4 trillion plus balance sheet and for all the discussion over the place of the reinvestments in the Exit, there is in fact not all that much in assets other than the roughly $10 billion a month in the MBS portfolio maturing in 2015 due to the earlier Twist operations that extended the average maturity of the Treasury holdings.
Ending the reinvestments was also originally meant as the opening bell to a drawn out approach to the actual first hike in rates while the new term reverse repos and term deposit facility were ramped up to drain as much of the excess reserves as possible. But the introduction of the overnight reverse repo facility has displaced much of the need for the TRR and TDF, while the end to the taper is essentially now providing the signal to the Exit countdown, whose timeframe is in fact more likely than not to be much more compressed than envisioned in 2011.
So while Committee members will be offering their own ideas and arguments about the timing, tools, and sequencing of the Exit — Boston Fed President Eric Rosengren suggested an interesting idea to put the end to the reinvestments on a measured pace much in the same way as the taper — two things are worth bearing in mind.
First, no major one piece of the Exit is likely to be agreed or made public until there is a firm consensus on the entire Exit architecture and its sequencing. And that, we still suspect, is unlikely before the September meeting. And second, above all, the premium will be on maximum flexibility when the Exit finally gets underway.