Fed: Upward Tilting

Published on March 21, 2017
In the days since the Federal Open Market Committee’s rate hike last week, there has been no small measure of confusion if not consternation in the markets over the Committee’s intended messaging takeaway, namely, whether the Fed meant for there to be such a dovish framing to the rate hike — in particular the insertion of “symmetric” in reference to the inflation target — that seems to reinforce a view that the Fed will be hesitant in the pace of rate hikes from here.
 
The short answer is no.
 
*** First, while there would be concern if a dovish market takeaway hardened into an insensitivity to upside data going forward, Fed officials are not really all that bothered by the market’s immediate reaction. If Fed officials at this stage of the policy normalization process had to choose between an underpricing versus an overpricing of its base case rate path, they would choose the former every time. The scars of the 2013 taper tantrum, it would seem, run deep. What’s more, there will be plenty of time to nudge pricing probabilities higher if need be in the run up to another rate hike down the road. ***
 
*** The reasons behind the reference in the statement to a “symmetric” inflation target were twofold. For one, it reflects the sort of language trade-off often needed to get to a Committee policy consensus. But more importantly, it was to reinforce and extend the gradual pace of the rate tightenings, an early marker to temper any “behind the curve” rise in yields further down the road if inflation temporarily overshoots the 2% inflation target. Its foreshadowing in this statement could be equated to the inclusion since March 2014 of the “below normal” guidance that rates would be running under normal levels in the past. ***
 
*** Neither of these two points, however, should detract from what we believe is a solidifying Committee consensus to keep to a quickened pace of rate tightenings relative to 2015 and 2016. The March rate projections did, after all, migrate higher across all three years even if the medians remain unchanged, and the FOMC has yet to fully factor in any fiscal stimulus. Our sense is that the FOMC wants the policy rate at or near its estimated current 0% real neutral rate, by this time next year. With that in mind, barring a downside shock in the data, we are raising our probabilities for a fourth rate hike at the June FOMC meeting. ***
 
A “Symmetrical” Inflation Target
 
In the run up to last week’s FOMC meeting, we were expecting both a rate hike (see SGH 2/13/17, “Fed: March Positioning” for the start to our shift towards March) and for its framing to be fairly dovish in tone, namely that the rate dot projections would, on balance, be more likely to stay at three rather than four hikes.
 
We also sensed that not all the voting Committee members were entirely comfortable with the March rate hike and that, as is invariably the case, a rate hike would also entail some compromises in the statement language to ensure as wide a consensus as possible on a rate move. That was, we think, one reason for the inclusion of the reference to a “symmetric” inflation target in the March meeting statement (SGH 3/15/17, “Fed: The Economy is Doing Well”).
 
But the reminder in this statement that the 2% inflation target was symmetrical — echoing the 2016 tweak to the “Longer-Run Goals and Monetary Policy Strategy” — was not intended to signal near term dovishness or a caution in further rate hikes beyond March.
 
Instead, the symmetric inclusion is being aimed much further out the policy horizon, to blunt any concerns that may arise or potential pricing that may emerge that the Fed was “behind the curve” if inflation should temporarily slip above the 2% target, perhaps some time next year or the year after.
 
The Yellen-led FOMC, in other words, may be unwilling to engineer an overshoot of the 2% inflation target –the anchoring of inflation expectations is much prized and in any case they no longer need to with the deeply diminished deflation risk — but they would be willing to tolerate a modest overshoot as they continue with the gradual but steady removal of monetary accommodation, confident in what they believe is still a very inertial rather than accelerationist inflation.
 
Its inclusion in this statement so far ahead of when it will be a major feature to the Fed’s policy stance can be compared to the “below normal” insertion into the March 2014 statement that even after the economy is essentially near mandate-consistent levels of employment and inflation — as it now stands — “economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.” 
 
Monetary Policy in Transition
 
In any case, we would stress the lean in the Fed’s policy stance coming out of its March meeting is significantly more hawkish than what the market seems to be assuming.
 
It is noteworthy, for instance, that the rate dot projections did migrate upward as we expected across all three years of the March forecasting horizon, underscoring the upward tilt in the FOMC’s consensus on the most likely path and pace of rate hikes (SGH 3/7/17, “Fed: Beyond March”).
 
But perhaps the clearest indication of the shift in the center of the Committee consensus towards picking up on the pace of removing monetary accommodation was in Governor Lael Brainard’s speech on “Transitions in the Outlook and Monetary Policy” a few days before the hawkish signals in Chair Yellen’s own speech in Chicago.
 
“We are closing in on full employment, inflation is moving gradually toward our target, foreign growth is on more solid footing, and risks to the outlook are as close to balanced as they have been in some time,” Brainard, one of previously most dovish voting members of the FOMC, declared in the opening sentences of her speech.
 
We admittedly had overlooked the significance of that speech, but it reflected an important milestone in the evolution of the broader Committee consensus.
 
Yellen echoed the same theme in her Chicago speech and again in the post-meeting press conference in laying out how the Fed will now essentially be getting back on track with its policy normalization, previously delayed or slowed in 2015 and 2016 by “a series of unanticipated global developments.”
 
In other words, the Fed is no longer in such a risk management mode as they were when concerns over being pushed back to the Zero Lower Bound weighed so heavily on the timing to rates lift-off and the pace of rate hikes that were to follow.  And that, in turn, is driven in large part by the new confidence in the outlook.
 
Nothing has changed in the Fed’s median forecasts for the most part, but that has been pretty much the point: not much needs to change to warrant the resumption of the gradual pace to removing monetary accommodation when economic growth looks to be on a steady, above trend track.
 
Indeed, the risks are to the upside when the economy is at or very near maximum employment and mandate-consistent levels of inflation. While the FOMC opted to still describe the near term risks as “roughly balanced” in the March statement, we suspect that if the data continues in line with the forecast, the “roughly” will come out in the May statement.
 
And that is for the most part before the FOMC majority begin to factor in a serious fiscal boost to aggregate demand that seems likely to feed into the growth forecasts for 2018.
 
A June Move
 
Even with the third rate increase in the policy normalization process behind them, the real fed-funds rate is still below zero, and our sense is that with the economy essentially at maximum employment, the FOMC would like to be at or very near its estimated current 0% real neutral rate by more or less this time next year.
 
Barring a downside shock or sudden softening in the data, this is pushing us to significantly lift our probabilities for a June rate hike, which in any case, will come into a clearer view once the Fed is past the low tail risk of the second round of the May 7 French presidential elections, and there is perhaps a bit more clarity on the US fiscal outlook.
 
A June move, we would add, would enable the FOMC to keep its options open for the timing to further rate hikes this year, while waiting until July or later would essentially mean making a decision by summer on the pace of rate moves through the rest of the year. 
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