Fed: Towards a Post-Threshold Framework

Published on January 22, 2014

When the Federal Open Market Committee adopted its twin numerical thresholds at its December 2012 meeting, they obviously knew they would have to eventually update the numerical rate guidance once one or both of the thresholds were crossed.

They just never expected it so soon — a 6.5% headline unemployment threshold looked far away at the time — but that moment is now nearing. As we wrote (SGH 1/17/14, “Fed: Goodhart’s Law and the Thresholds), the most recent Nonfarm Payroll’s drop in the headline unemployment rate to 6.7% is forcing the FOMC to move sooner than expected on a post-threshold framework for its forward policy guidance. And right now, they are still a long way from a consensus.

*** We expect next week’s first of the year FOMC meeting to continue with another $10 billion taper in the flow of bond purchases to $65 billion a month. The FOMC will also be revisiting its annual Statement of Longer Run Goals and Monetary Policy Strategy, but otherwise few changes in the statement. Policy guidance is likely to be the main topic of discussion, but any changes seem more likely at the March meeting. ***

*** While it is early days for a consensus to be taking shape on a new guidance framework, there does seem to be a momentum of sentiment towards replacing the numerical thresholds with a more purely qualitative guidance, perhaps fleshing out the meaning of the “well past” phrasing for a first rate hike of the December statement. The qualitative guidance may lean heavily on inflation to guide the reaction function, and for rates staying low to guard against persistence low inflation. ***

*** The Fed’s forward guidance will only be tested for the first time this year amid the brighter growth outlook, and any shift to a more qualitative guidance will invariably put an outsized weight on the “dots guidance” of the first year rate hike and year-end fed funds projections. That will mean the FOMC will have to ensure the dots and the appropriate policy path and underlying model assumptions of the 19 Committee members hew as close as possible to the intended guidance of the formal statement of the voting Committee members. ***

Growth and Taper Signals

There is, a least, a consensus right across the FOMC on the brighter growth prospects this year. Even those with the lower real GDP projections are likely to revise upward, and most are eyeing the upper end of or just above the December SEP central tendency range of 2.8%-3.2% for 2014 and even better in 2015.

The better looking growth is all for the usual reasons: decent underlying demand and spending, healthier balance sheets, banks with the capital to support greater lending, a housing market still on the upswing, and with all this underlying momentum free of the restraints of fiscal policy or derailment in the spillover damage from Europe’s self-inflicted blows.

That elusive, but long sought “escape velocity” of a self-sustaining recovery, it seems, is this time finally on the near horizon.

Both the Fed and the markets have been here before, of course, three times in fact, and in each case early optimism gave way by every spring since 2011 to sputtering momentum and the downshift to a vulnerable subpar pace to the recovery. But this year promises to be different, if for any other reason, because last year turned out to be far better with more momentum than the Fed forecasters were expecting right up until the few weeks going into the December meeting.

In fact, it looks like Chairman Bernanke was right last summer on the expectations of more durable growth even if he was a bit premature on the market’s readiness to take the taper is not a tightening message on board. You live you learn.

Indeed, that better looking economy (sans that goofy NFP print) is providing the backdrop to the case being made by several of the FOMC’s usual suspects to accelerate the pace of the taper. And even some of the more dovish acknowledge the prospect, and we likewise raised the possibility if the strong data continues going into the March (SGH 1/9/14, “Fed: The Minutes, The Morning After”) or especially the June meeting.

But we believe the numbers would have to be unmistakably strong to trigger an acceleration. For one, the measured pace is already priced into the market and essentially out of sight out of mind for most aside from headline writers, so for the Fed, why stir things up again? The stock of accommodation, whether the taper remains measured or accelerated, is more or less the same.

More to the point, the effect of any taper acceleration would be its signal in bringing the timing to the first rate hike forward, which for now, the Fed is unwilling to signal. And so for now, the FOMC’s taper discussions is really about how pressing it is becoming to sort out what to do with the Numerical Thresholds now that headline unemployment is within shouting distance of the 6.5% threshold.

That Labor Participation Rate

That reality, is likewise the endpoint to the long discussions over whether the perplexing fall in the labor participation rate is structural or cyclical.

The balance of views within the FOMC has been steadily shifting towards its structural underpinnings rather than its cyclical causes, and it is an enormous source of debate and research within the Fed system since it has such a determining effect on the estimates of where the longer run unemployment rate lies.

But for now the dominant view remains that for all the structural reasons for the falling LPR, enough of it is still cyclical to warrant exceptionally ample accommodation. The suspicion is that the LPR will soon stabilize and as the headline unemployment rate continues to decline, it may even finally begin to rise a bit.

And how much of that “structural” unemployment is in fact cyclical — if there is enough demand and jobs are on offer, the workers will show up — will only be more apparent when wages finally start to lift from their flatlined floor. And that is a good outcome, not necessarily a bad one after years of positively flat wage growth.

So until then, rates can be kept lower for longer and “well past” the now hawkish looking 6.5% headline unemployment threshold.

Indeed, it is perhaps fair to say the biggest impact of the labor participation rate mystery for now is not so much about any potential changes in the current policy path as much as it is another reason forcing the Fed to revisit its forward guidance sooner rather than later.

The threshold-framed forward rates guidance looked to be working fairly well by year end in overcoming the taper tantrum that derailed a first taper in September. Market pricing, for instance, has been more or less aligning with the “dots” guidance in the September and December quarterly SEP first year rate hike and end of year fed funds rate projections.

But so far, the forward guidance has been in the context of a subpar growth in the economy, so what was there to lose in pricing alongside the Fed’s own guidance if the economy was still shy of self-sustaining pace that would put upward pressure on rates and across the yield curve. As we noted late last year (SGH 12/20/13, “Fed: Well Done, But a Testing to Come), the efficacy of the forward guidance will only be truly put to the test amid the brighter growth prospects of this year.

Post-Threshold Options

We expect the FOMC meeting to be fairly uneventful in terms of few changes in the statement or its policy stance. The taper is all but certain to continue with another $10 billion decrease to $65 billion, and for few if any changes in the guidance language. The FOMC will also be discussing and issuing its annual Statement of Longer Run Goals and Monetary Policy Strategy, and changes there likewise seem unlikely.

Instead, the main topic of discussion during Ben Bernanke’s last meeting in the chair will be revisiting the forward policy guidance. The Fed is already painfully aware the 6.5% unemployment threshold is edging towards its sell-by date, and has already lost most of its relevance as a policy guide since the Fed has already successfully signaled it has no intention to raise rates or even think about them at the 6.5% mark.

The FOMC will be weighing several options on its post-threshold framework at the January meeting, which will hopefully be shaped into a consensus for a new guidance framework by the time of the March meeting.

Perhaps the easiest that will be put on the table again is to simply change the threshold from 6.5% to 6%; after all, they already effectively lowered it from the 7% being debated prior to the December 2012 adoption of the 6.5% threshold. But there remains little to no momentum to do so, as there are just too many who argue it would be too risky since they believe the longer run unemployment rate is higher than the more dovish are assuming. That, in any case is the takeaway in their minds to the falling participation rate and what they see as its structural causes. If the Committee didn’t tweak the unemployment threshold to 6% in December, there is even less chance of doing so in March.

Another idea being kicked around to replace the 6.5% threshold with a range below, say, between 5.5% or 5.75% to 6.5% as a corridor for where the FOMC will be monitoring much more closely the wider array of data such as the hire and quits rate, the LPR and the like when trying to gauge the health of the labor market in weighing a rate hike.

But it too has its share of difficulties. For one, alongside the need to revisit the guidance is a desire to simplify and shorten the FOMC statements, and layering in a new corridor on the other side of the 6.5% threshold, much less listing all the other data points, or for that matter, bolting on the lower band to the inflation threshold is complicating, not simplifying matters.

Instead, it feels like the momentum within the FOMC is moving more towards a more purely qualitative guidance by the time of the March meeting. That could entail moving from the thresholds altogether and essentially fleshing out the “well past” phrasing put into the December statement to signal the FOMC’s determination and the likelihood it will keep interest rates lower for longer than in a more “normal” rate tightening cycle.

There are two things that will be considered in any move to a more purely qualitative guidance. The first is that it is very likely to lean hard on the inflation rather than the unemployment mandate. While the labor market data is proving problematic and providing less clear signals on the recovery, the policy path from here may be better served and the Fed’s reaction function more clearly indicated by the developments on the inflation front and in measured wage pressures. It will certainly be more of a common theme to many speeches by Fed officials in the coming months.

A Greater Reliance on the Dots Guidance?

The other point about a more qualitative guidance is that it may be unlikely to be as effective as the quantitative guidance of the numerical thresholds. And that means even greater weight will be on the dots guidance.

But that, in turn, is a bit more problematic in a strategic sense since there is essentially no guarantee the dots of the 19 individual committee members, all based on their own assumed appropriate policy rate, will hew closely to the intended guidance of the formal statement of the voting committee members.

For instance, some of the more centrist committee members may be modestly moving their “dots upward or forward in the March SEPs, reflecting the effect on their appropriate policy path of the stronger growth outlook. The timing to the first rate hike and the implied trajectory may still be lower and slower than under more traditional Taylor Rule assumptions, but December’s dovish cluster of dots may give way to a taller, thinner dispersal of the dots that might be confusing and hard to communicate.

For many if not most of the FOMC members, there remains a powerful intellectual argument to continue with the December dots guidance for a very dovish policy path, perhaps even more so if the taper by March will have reduced the QE accommodation by a third or so; after all, that is what the “changing the mix” messaging was all about; no actual change in the level of accommodation, just in the tools used and the channels to transmit that accommodation and a subsequent change for the better in the cost/benefit.

So if the optimal control path is to remain intact and infusing the consensus of the March meeting, the dots may need to provide the main anchor to lower for longer rates guidance, especially if coupled to another taper and a shift in the statement to qualitative rather than numerical guidance.

The new chair Yellen and her FOMC colleagues, in other words, will have their work cut out for them next week in the start to forging a consensus on the post-threshold guidance to take policy and the markets to the next phase of a post QE world.

It would be something of a miracle for that consensus to fall into place at the meeting next week, but it will invariably need to at the March meeting if the Fed wants to avoid losing control of the messaging on rates and the curve. We do think the speeches and public remarks of Fed officials after January are likely to reflect the degree to which the FOMC can narrow down its guidance options, and that an inflation rather than employment narrative will be accented.

A major policy speech outlining an update on the so-called optimal policy path, and making a convincing case for the underlying arguments why rates can and need to be kept lower for longer would go a long way to easing any risk of rate volatility. That may be unlikely before the March FOMC meeting, but perhaps soon after. In any case, the Fed is well aware that the much sought escape velocity of the recovery is near though not here yet, and a bad misstep on the guidance could still derail things.

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