That Federal Reserve Chairman Ben Bernanke was about as dovish as dovish can be on interest rates that will be held very low for an awfully long time was hardly a “stop the press” take-away from his speech last night before the Economic Club of Washington.
Nor, for that matter, was it a surprise that he spoke only in the vaguest of terms over the timing of the long awaited first downward adjustment in the $85 billion a month in bond purchases or the ways to reinforce the Fed’s forward guidance on rates.
Simply put, that is because that is as far as the consensus within the Federal Open Market Committee has gotten, which is likely to be reflected in the thrust of the October meeting Minutes later today.
*** The Minutes are likely to show the FOMC has already reached a consensus in broad strategic terms on the need to continue with an extremely accommodative monetary policy, and that going forward it should increasingly rely on rates policy and forward guidance as the more suitable primary policy tool at this phase of the recovery. That, in turn, will necessarily entail the much messaged “changing of the mix” towards guidance and the winding down of QE.***
*** While it may seem obvious, the decisions from here are purely tactical on the taper timing and the reinforcing and sequencing of the rates guidance. Both decisions will obviously be driven by how the upcoming data — the November Non-Farm Payroll in particular — shapes the forecasts. But the single most important driver to these near term tactical decisions will be a high level of confidence the taper will not trigger an undesired tightening of financial conditions in a repeat of last summer’s misfire. ***
*** The range of the options in changing the mix between the two policy tools is already being bracketed by the most dovish and hawkish stances taken in recent speeches by FOMC members, and the challenge before Bernanke in his final days and especially for Chair-designate Janet Yellen will be to forge a consensus through a likely trade-off between the taper timing and the robustness of the forward guidance with a minimum of dissents.***
*** Against that backdrop, we believe that first taper could still come, however lower the probability, as early as December – Bernanke carefully left the door open even as much as he sounded in no rush – and no later than March. One or more reinforcements of the rates guidance, on the other hand, will almost certainly come in December, with or without a taper, as the FOMC will probably be keen to test drive the impact on expectations of an even more accommodative “lower for longer” rates outlook. ***
Three Themes to the Minutes
We expect three main themes to emerge in the Minutes that will be released this afternoon. First, even though the Fed for the most part was pretty confident the outlook would still look reasonably good on the other side of the shutdown noise in the data, they were nevertheless meeting amid no shortage of uncertainty over just about everything that matters, be it the fiscal outlook or why and how the communications went so awry in the run up to the September meeting.
But as we noted, the Minutes should clearly reflect a common view that policy will invariably need to be highly accommodative for as long as necessary to ensure a sustained recovery. And in that context, the Minutes are also likely to underscore the crucial difference seen between changing the extent of the Fed’s stimulus and changing the mix between the two main policy tools for the one deemed most suitable for this phase of the recovery, or in this case, for rates and the guidance at the expense of purchases.
As Bernanke noted in his remarks, and to which there is a solid consensus within the FOMC, the uncertainties over the exact channels and effectiveness in the transmission of bond purchases compared to the better known and more easily modeled rates policy almost naturally points to their greater reliance on the latter over the former – especially at this stage of the recovery and when the escalating size of the balance sheet is creating additional uncertainties for the Exit.
That, in turn, points to a third likely theme, namely what is probably going to be a lengthy take in the discussion section of the Minutes over what the options are to strengthen and better sequence the rates guidance. One would think that since they have been debating the adjustments in the thresholds since at least June that October should show the FOMC approaching a put up or shut up moment in teeing up a decision for the December meeting on that front.
We do not have the sense a consensus has come together yet on either the taper timing — other than we just wish they would get it over and done with — or how the rates guidance may be reinforced. But December is clearly shaping up as a critical inflection point for decisions on both fronts, not the least of which on whether to adjust the thresholds since they have been damn near debating it for half a year.
Working back to front, we do not rule out a December move if the market continues to move towards assuming a first downward adjustment — and the sooner the first taper, the smaller its first go will be — and in particular, if the market looks to be pricing in a minimum of higher yields or bringing a first rate hike forward against the Fed’s likely new guidance pushing the first rate hike further out.
But even then, this is an FOMC that will be very cautious and unwilling to take any chances of a redux of the summer misfire that saw yields spike and such an undesired tightening of financial conditions. That alone, as much as they wish the taper debate would be over and done with, may make the FOMC cautiously opting for a first taper in the first quarter of next year, but no later than March.
There is no particular rush to end QE, namely because the cost factor is not yet a driving factor as both Yellen and Bernanke have stressed in their recent remarks. Yes, QE’s costs will steadily rise in terms of the size of the balance sheet that will have to be managed in the eventual Exit, or in the way the bond purchases are potentially impairing price discovery or especially in distorting investment decisions (whether Fed officials will admit it or not) while its benefits will steadily diminish the longer it goes.
The data is obviously a factor in driving the first opportunity to weigh a taper, and the barest supportive data between now and the December 17-18 meeting will signal a necessary but still not sufficient reason to begin a taper.
That trigger instead will be the conviction or at least a very high degree of confidence the communications offensive to de-link the taper from a tightening has finally sunk in and will dampen the rise in yields and market volatility when the tapering finally gets underway.
A Crucial Taper not Tightening
That is, in fact, likewise the main takeaway we had to yesterday’s abundantly dovish arguments laid out by Chicago’s Charles Evans. He certainly made it clear he is in no rush to begin the tapering, and even upped his expectations of a total stock of QE accommodation to a “ballpark figure — a rather big ballpark we might add — of as much as $1.5 trillion in bond purchases before it is wound down.
The Chicago Fed even tweeted under his name he thought QE could run “until January 2015,” though the tweet was later corrected to “from Jan 2013 until we wind this down.”
Contrast that with the more hawkish stance bracketed against Evans by Philadelphia’s Charles Plosser, or this morning by St. Louis Fed President Jim Bullard that a taper could and should be on the table in December.
It will be on the table, but the point Evans was making and shared by all the FOMC is that the tapering should only begin when the FOMC is as certain as they can realistically be that it or even strongly hinting at it will not trigger a repeat of last summer’s misfire.
And thus, the heavy focus in the October meeting on communications and the ways to reinforce and sequence the rates guidance, which Yellen more than a year ago described as “the centerpiece of appropriate monetary policy.”
The one year anniversary of introducing the Numerical Thresholds would be a fitting moment to revise them to better reflect the FOMC’s assumptions the thresholds are not triggers. But for our two cents, we still suspect the bias going into the meeting may still be leaning to no change in the thresholds, but to instead opt for a greater clarity on the likely reaction function with rates once the threshold is crossed.
There will be, we think, decent grounds for holding off on any tweaks to either until the FOMC sees more evidence on how the interplay between the headline employment rate and the participation rate plays out, and on whether those dis-inflationary pressures are indeed “transitory” or proving more dangerously persistent.
That could mean a greater reliance on the so-called “dots” guidance of the first rate hike and year-end fed funds rates in the December Summary of Economic Projections. It is an unwieldy tool since FOMC members go into the meeting with their projections, and tend to be reluctant to move them around after the conclusion of the meetings even if it can be done. But it is potent if done and messaged right.
There are also other ways to guide the market to the Fed’s likely post-threshold reaction function of holding rates low for longer than anticipated. It could come through further details on the broader labor market measures that will be increasingly important as the headline rate continues its decline.
There is also the affirmation in the statement itself of the often-cited intention to hold MBS assets on the balance sheet, or likewise putting the formal stamp of the statement on the expectation the longer run near 3.75%-4% neutral fed funds rate will lag reaching trend levels on growth, employment, and inflation by several years.
All or at least some of the above options may look attractive to lay out in December. And that would be the case whether accompanied by a first taper, which again, would probably seem chancy by the majority of the FOMC, or as we suspect the FOMC would prefer, to be laid out first in a sequencing to ensure the market has fully taken on board the taper is not a tightening messaging.