For all the weighing of probabilities over the “patience” forward guidance language in Wednesday’s Federal Open Market Committee’s March meeting statement, its fate may prove less consequential to market pricing than how far the Committee can get to a consensus on the likely pace of the rate tightening cycle and, equally, how far Fed Chair Janet Yellen can go in laying out the base case for that path in her first year anniversary press conference.
And so on that line of thought, a few points on the likely takeaways from this week’s FOMC meeting:
** We expect Chair Yellen will want to move the Fed’s next phase of messaging on rate policy normalization to its most likely pace from the probabilities on its first hike timing, so that consensus on the base case path will be crucial. In fact, as we have touched on in a previous report (see SGH 3/6/15, “Fed: Getting There”), we suspect protecting a long shallow path will prove as if not more important to the FOMC and its messaging in the months ahead than the expected guidance changes to maximize the FOMC’s flexibility on the timing to that long awaited first rate hike.
** On the “patience” language, we share the view it is all but certain to come out or be modified with new language affirming a “meeting to meeting” approach after April that will be assessing the data for continued labor market gains and firmer evidence on an upward movement in inflation that would allow the FOMC to be “reasonably confident” in a movement back to the 2% target within a few years. We also expect a further nudge down in the core cluster of the 2015 blue dot rate plot to around 1% as well as lower longer run unemployment and neutral interest rate assumptions, though testifying to a greater certainty on rate hikes rather than a dovish retreat.
** Chair Yellen is likely to strike a careful balance in stressing the Committee’s post-April policy flexibility, but steering shy of committing any more firmly to a June meeting rate hike beyond that it should be respected in market pricing. A Committee consensus on the likely pace of rate hikes would also allow her to highlight that gradual path to help dampen some of the inevitable market volatility around a first rate hike. Likewise, a long, slow removal of monetary accommodation could also lessen the risk of rapid hike rates further down the road to ensure inflation doesn’t rise by too much or for too long beyond its 2% target.
** And it is our sense a Committee consensus is indeed coming together, hopefully as early as this week, for a very shallow rate tightening stretching across several years to at least the end of 2017. A first rate hike, whether as early as June or as late as September, is unlikely unless the FOMC is fairly certain it can lift rates two or more times during an initial phase that, in turn, could be followed by an extended pause in the first half of next year to assess its impact. It is this prospect for one or more extended pauses across the gradual arc of coming tightening that distinguishes it from the more mechanical rate hikes at every meeting in the 2004-2005 rate tightening cycle.
** Crucially, the consensus on this rate path is premised on the re-emergence of Phillips Curve linkages between unemployment and inflation becoming more apparent in the data through the course of this year. The decline in the headline unemployment rate should slow through 2015 as more part time and discouraged workers are pulled into the labor force, and a broad-based wage growth should begin to surface in the data by the end of the year as the unemployment rate pushes through the lower estimates of the longer run levels, with core inflation slowly moving more consistently towards its 2% target later in 2016 or even 2017.
** It is this expected inertial and slow moving momentum to inflation that is crucial to allowing for the gradual rate tightening. Under this base case rate scenario, the FOMC would want to bracket those 2016 mandate levels of employment and inflation by lifting the federal funds rate off the zero lower bound no later than September this year, cautiously raising rates to around 1% by the time wages are rising more broadly and consistently around the turn of the year, and to arc the tightening cycle across 2016 and 2017 with extended pauses along the way to reach a neutral interest rate assumed for now to be at around 3.5% by the end of 2017.
** The pace of rate hikes will be faster or slower depending on the reaction of the financial markets and how effectively and smoothly the policy stance is transmitted into the real economy. But while that may be true once the Fed has a better handle on the transmission mechanism, the reaction function is in fact likely to be much more asymmetrical during the initial rate tightening, in that the FOMC will probably be more willing to tolerate a flattening yield curve in a repeat appearance of the so-called “Greenspan conundrum” than if yields spike on the market pricing in an excessively rapid rate trajectory that replicates the 2013 taper tantrum or the 1994 rate tightening cycle.
** We still lean somewhat to a more cautious September first rate hike, but we do not fail to appreciate how long the FOMC has been eyeing a June rates lift-off (see SGH 9/23/14, “Fed: The Dots and the Trajectory”). That will tend to put a certain burden of proof on those arguing for a more cautious delay to September. Core inflation, however, may come up short by June in showing much in the way of clear evidence it is edging back up towards 2%. What’s more, regardless of the Committee wanting to move away from the explicit forward guidance or its assertion of live meetings after April, the FOMC will not want to risk market dislocation by going into its June meeting without a signaling of its likely rate decision. That, in turn, makes the data in the first half of May and the last half of the month the crucial messaging period for first rate hike probabilities in June.
** The FOMC, and Chair Yellen in particular, will want to be careful in their messaging by then to ensure passing on a rate move in June is not taken as a dovish signal they won’t be moving in September either, or July, or even later. On that front, we suspect the arguments may emerge if needed in major policy speeches in April or especially May that there could be as high a cost in waiting too long to move on rates as there is in moving prematurely: the risk of moving too soon and embedding low inflation expectations or misreading how sensitive the real economy is to higher rates would have to be weighed against the risk that the longer the FOMC waits, the more likely the market will price in the “later but faster” rate trajectory and the harder it will be to reverse the higher yields before they potentially derails the recovery.