It would be hard not to notice the unusually well-disciplined communications offensive by Fed officials since the turn of the year with the well telegraphed messaging of “patience” on rates policy and “flexibility” on the last legs of their balance sheet normalization efforts.
There is, of course, far more nuance and risk management calculations — those “cross currents” of risks — shadowing these twin tracks of rates and balance sheet policies. And importantly, underpinning the Fed efforts to regain control of the twin tracks of its policy narrative possible is an almost transformative Committee consensus view on the dynamics of the inflation process, an understanding that now assumes a more expectations-driven, inertial or “muted” inflation across the near forecast.
Four main takeaways:
*** On rates, the inflation no-show removed the explicit bias to tighten, but there is, for now, no lean-to ease either: it is still near impossible to find a Fed official who expects this year’s slowing growth to downshift into recession. It would, in fact, be more accurate to frame the FOMC stance as an implicit bias to tighten, in that the higher probability for the next rate move is still up not down. And while we expect the March rate dot plots to flatten across the three-year projections, there is still likely to be a modest upward trajectory, including a single rate hike this year. ***
*** That said, the current stance could still turn on a proverbial dime and the bar to that “next” rate hike is fairly high: the Fed’s reaction function is no longer pre-emptively driven by further falls in unemployment or stronger wage growth, but instead a lagged response to clear evidence of upward trend inflation or a sustained rise in inflation expectations. With near term inflation so muted, the Fed’s “patient” stance aims to guard against costly though low odds downside risk, and to coax anxious markets away from what could become self-fulfilling recession expectations. ***
*** On the balance sheet, the inertial inflation is essentially freeing the FOMC to double down on its normalization plans, and the December messaging misfires added a sense of urgency to a quicker than expected consensus in January, including: the adoption of a floor system as the operating framework going forward, and a “large” balance sheet with reserves somewhere near the $1 trillion mark. The Committee, in principle, also agreed on the merits of slowing the pace of capped assets run-offs to probe for where the reserve demand curve starts to steepen. ***
*** We now expect a second statement to update their progress at the March meeting, or in May at the latest, on the target terminal size of the balance sheet and level of reserves, as well as a timeline and scale to the tapered asset run-off. The current capped run-off would put the reserves at around the $1.25 trillion mark by October; but depending on the new pace of the taper, and how soon it would start — the Fed intends at least a three-month forewarning to prepare the markets – it could push the end to the balance sheet normalization to the turn of the year or early 2020. ***
A Changing Sense of Inflation Dynamics
The Fed has effectively removed itself from the list of policy error risks through its solid consensus messaging on a “patient pause” over recent weeks. But there remains an apprehension in the markets over what seemed to be such a stark volte face shift in the Fed policy stance between the seemingly hawkish December meeting messaging to the more soothing dovish takeaways from the January meeting.
Perhaps even more perplexing was Chairman Jerome Powell’s observation at his January meeting press conference that there was in fact no significant change to the outlook. Instead, there were “cross currents” of risk on the near horizon that argued for a more cautious risk management approach. Left unsaid, however, was that those same cross currents were just as present in December as they were in January.
In hindsight, however, the FOMC was neither as hawkish as it was interpreted to be in December nor as dovish in January as the market took the day’s communications. And while Powell was faulted for somewhat mangled messaging in the post-meeting presser, the larger issue was a a newly divided Committee on the inflation risk.
Indeed, the bridge between the two meetings was a near transformative shift in how the FOMC has come to see the dynamics of the inflation formation process, namely, that it is even more inertial than previously believed, and driven far more by anchored and somewhat weakening inflation expectations rather than an overheating labor market and stronger wage growth.
The long assumed link between inflation and slack has been weakening for some time, of course, and since the Great Recession, the Phillips Curve has more or less been flattened into near oblivion. In parallel, the expectations component to inflation was increasingly all but supplanting the Phillips Curve assumptions in the forecasting models to explain the inertial nature of inflation, certainly since the financial crisis (see SGH 9/26/18, “Fed: A Still Assumed Inertial Inflation”).
Across last year, for instance, core inflation was never forecast to build much momentum and even in September last year, more or less the height of the FOMC’s hawkish consensus (see SGH 9/20/18, “Fed: September Messaging”), inflation was still expected to trend mostly sideways, with only modest overshoot of the 2% inflation target.
But going into the December meeting, there was a mounting disquiet among more than a handful of the more dovish FOMC members over what seemed to be a softening inflation, despite the fiscal stimulus and expectations for the labor market to push even further below most NAIRU estimates.
Vice Chairman Richard Clarida seemed to align with the Committee’s two most dovish members when in an important speech just before the December meeting blackout, he fretted that various measures of inflation expectations were falling — the same speech where he first described inflation as “muted,” a phrase that would made its way into the January meeting statement.
Even though the FOMC ultimately retained the tightening tilt in the guidance language of the December statement, they tried to soften its impact by wrapping conditional language around it, and Powell made a point to note the drop to two from three rate hikes in the 2019 rate dot projections. And the language was almost certain to come out altogether in January.
By the time of the January meeting, the FOMC was looking at high probabilities for inflation to drift slightly lower through the first half of this year, even with the economy still “in a good place.” The transition to a wider embrace across the FOMC for a near total absence of an upside inflation risk was all but complete by the time Powell went before the press to noted the muted inflation and to drill home the patient pause message.
Balance Sheet “Flexibility”
This newly unified Committee consensus on a low inflation risk not only afforded the Fed the luxury of turning to the “patient Powell pause” through the first half of this year, it also freed the Committee to double down in rapidly moving forward to compete its balance sheet normalization plans that were first mapped out in June 2017 and launched the following October.
The FOMC in fact made much more progress than they were initially expecting at the January meeting, getting to a consensus on key broad issues. With an eye to avoid the market turbulence of the December meeting, their progress was put into a somewhat rushed two-point stand alone statement to keep its technical nature distinct from the main policy statement.
First, the reference to “ample reserves” in the statement was meant to convey the FOMC consensus to retain the current “floor” system going forward, in which rate policy would be executed primarily through the administered Interest on Reserve rate. Still to be determined is whether to distinguish the rate paid on required versus excess reserves, and whether to tier the rates paid on excess reserves, both to encourage a deeper fed funds market and to reduce the bad political optics of paying the banks a “subsidy” on the reserves.
And addressing some of the sensitive internal governance issue, the policy target will remain the fed funds rate, or some future refinement of it, debated by the full FOMC and set by its voting members, then handed off at the same “joint meeting” to the Board of Governors, which then implements the FOMC instructions by voting on the IOR rate.
The Committee also resolved the great debate between a larger versus smaller balance sheet, with the Open Market Desk essentially convincing the FOMC how difficult if not impossible it could become in hitting a point fed funds target under a scarce reserves system without potentially massive daily market interventions — the very sort of big market “footprint” the institutional hawks were keen to avoid.
The large balance sheet likewise means a far larger balance of reserves to be kept as liabilities on the Fed balance sheet and liquid assets by the banks. The large reserve balance is something of a concession to the arguments the larger scale of reserves held by the banks as high quality liquid assets to meet their regulatory liquidity requirements provides something of a pre-emptive safeguarding against the sort of systemic runs on liquidity that nearly devastated the global economy during the financial crisis. That becomes a particularly strong argument in light of the Fed’s potentially limited Section 13-3 powers.
There has been no decision on the eventual equilibrium level of reserves to be kept on the Fed balance sheet, but total reserves somewhere near the $1 trillion mark seems more or less to be a working assumption, with an additional “buffer” of perhaps $250 billion. Fed staff work and market surveys are underway to prepare presentations for the March FOMC meeting for best estimates of the true reserve demand under current financial conditions and changing market structures since the pre-crisis era.
And in the same vein, the Committee also agreed on the merits to slowing, or tapering, the pace of the $50 billion a month in capped asset run-offs, in order to more carefully calibrate the approach to the equilibrium level of reserves and avoid an overshoot into scarcity that could trigger excessive money market volatility. The extinguishing of reserves is at the current pace likely to hit the $1.25 trillion mark by October, and so the eventual end to the balance sheet reduction may still be reached this year though it could stray into early next year.
The intention is to announce at least a quarter in advance before the taper would begin to prepare the market, and with it, the target terminal size of the balance sheet. That could and probably will come as soon as the March FOMC meeting though technical details could still push a final decision and revised statement to the May meeting.
But the FOMC would ideally like to complete its final balance sheet plans and principles during the “pause period” on rates. The probabilities are so low on upside inflation risks through at least the summer, and any upside, or downside, surprise could force an earlier than planned response on rates, invariably complicating their best efforts to keep the balance sheet and rate policy on twin but distinct, parallel tracks.