In recent years Federal Reserve Chair Janet Yellen has tended to give a major, one wants to say seminal, policy speech each spring and fall, methodically laying out the key conceptual underpinnings to the Fed’s policy framework and usually providing a roadmap to the Federal Open Market Committee’s consensus outlook and policy path.
Her luncheon speech tomorrow at the Economic Club of New York is likely to be along those lines, and judging by the market’s continued confusion over the conflicting messaging from the Fed since its March meeting, it will need to be.
*** Despite the market chatter of a “revolt” within the Committee at the March meeting, however, our sense is nearly of the opposite, a reasonably solid consensus on most key matters. The FOMC, certainly its voters bar one, widely agreed on a prudent pause in the pace of policy normalization, driven in part by a risk management caution until there is further clarity on the global outlook and the direction of inflation expectations. There was also an “enhanced” awareness of the potential undesired exchange rate effects on the forecast in a March rate rise and what it would have signaled about the pace of subsequent rate hikes. ***
*** More importantly, the dramatically lowered longer run neutral fed funds rate would appear to reflect an unusual degree of consensus across the Committee to align the assumed appropriate policy path to a somewhat gloomier assessment of the economy’s potential. This more fundamental shift in the assumptions underpinning Fed policy, in turn, contributed to the slower projected pace of rate hikes for what was essentially an unchanged forecast. The issues surrounding the Fed’s conceptual framework and the differing views on the inflation process may be among the topics addressed in Chair Yellen’s speech tomorrow. ***
*** The March rate pause was driven by both a prudent caution when still so near the Zero Lower Bound and the more fundamental reassessment of the growth and inflation outlook, but we nevertheless believe its dovishness will make it more likely, not less, that the FOMC will be leaning towards a June rate hike. The revised 2016 year-end projections from four to two rate hikes make a December rate hike also very probable, and while an April move is unlikely, a “bridging” third rate hike in September should not be entirely ruled out, depending on how the inflation dynamics play out through the year. We consider the risks to the current base case rate path to be to the upside. ***
Policy in an “Environment of Ambiguity”
Amid the obvious complexities of setting policy in an “environment of ambiguity” as one FOMC member recently put it, there has been no small amount of confusion in a market whipsawed in the days since the Fed’s March meeting by what seems to be conflicting policy signals in the messaging of a “data dependent” policy path, an abruptly dovish downshift in the FOMC’s March meeting rate dot plot, then followed by a spate of relatively hawkish speeches by some Committee members. Little wonder there has been chatter of a “revolt” within the Committee.
We rather doubt, however, there has been anything like a revolt — these are central bankers after all — and in fact a surprisingly broad consensus across a number of issues seems to have prevailed in the March meeting discussions. And there is in fact a fairly steady coherence in the policy reaction function threading through the seeming twists and turns in recent policy messaging, which Chair Yellen may underscore tomorrow.
The key for us as we noted last week (SGH 3/16/16, “Fed: To Drive Inflation Higher”) was in the point made by Chair Yellen several times in her post FOMC press conference, that “achieving economic outcomes similar to those anticipated in December will likely require a somewhat lower path for policy interest rates than foreseen at that time.” In other words, the forecast for the real economy did not change all that much — on that, there was considerable Committee consensus — but the policy path itself had to be adjusted by quite a bit to achieve the same outcome.
Two things to note. The first was the broad-based FOMC consensus view, bar one dissenting voter, on the well messaged merits of a rate pause in March. As we noted in the run up to the March meeting (see, for instance, SGH 3/2/16, “Fed: A Tactical Pause”), this tact was driven by a straightforward risk management caution in moving rates when so near the Zero Lower Bound amid so much ambiguity in how to read the growth and disinflatinary developments abroad.
There indeed seems to have been a near consensus at the March meeting in a higher weight given to the potential impact of international developments. While &Fed forecasters still share little of the market’s gloom over a hard landing in China or the duration of Europe and Japan’s stalled growth, they did seem to factor in much more of how the Fed’s policies could darken the global outlook and then feed back through the exchange rate into lower growth and inflation projections at home. It has been a theme building inside the Fed since at least last October, and by March it would appear to have reached the point of a consensus view.
In addition, there was an equally felt sense of caution in the downward drift in inflation expectations; whether market or survey-based, or however much or little weight some Committee members put on them, the majority of the Committee, including hawks, seem to have concluded they were simply too low for comfort.
The Implications of the Lower Neutral Rate
But the second factor shaping the Fed’s March decisions and indeed its likely reaction function going forward looms even larger, namely, the dramatically lower estimates of the longer run neutral policy rate.
For an estimate of a longer run equilibrium interest rate that would normally be rarely adjusted, the steady declines in its presumed level in recent years have been nothing short of remarkable. Most Committee members had put their longer run neutral estimate as high as 4.5% with none under 4% in the first published dot plot in early 2013. And while the decline has been steady since 2013, it has been especially marked in the wake of the FOMC October meeting last year that opened with a special staff presentation on the new research on the equilibrium real interest rate, or R*.
In the December meeting that immediately followed, many Committee members adjusted down their longer run neutral estimates, and by March, the rest of the Committee followed suit. Currently, no Committee member is marking their neutral dot above 3.5% and more than a third of the Committee is marking theirs as low as 3%, for a new median of 3.25%, or a full percentage point drop from the 4.25% median of just a few years ago.
The lower neutral rate marks a pretty fundamental shift in the policy framework towards what is essentially a more secular stagnation view of the economy — an ongoing shortfall of demand relative to supply, and its relationship to the changes in the financial markets and a surplus of savings over investment – and it has been underway for some time. But once that longer run neutral level comes down, it follows the amount of “tightening” that will be needed across the three years of the forecasting horizon will need to come down as well as its pace if the Fed is to keep economy on its projected track towards fulfilling mandate-consistent levels of inflation and employment.
A March rate hike, in that sense, would have signaled a high likelihood of an FOMC intention to follow through with those other three hikes that, as the FOMC seems to have discussed at their March meeting, would have simply been too much in their impact abroad and on the dollar, with all its looming consequences on US growth and inflation. It was not that the decision to begin the long process of policy normalization with that first rate hike in December was a policy error in itself, but rather March was about correcting the December rate projections that were already looking outdated in being relatively unchanged since practically the summer.
There is little wonder then that for all the ongoing communications problems with the rate dot plots, this time Chair Yellen fully embraced them, and they could be seen as a (corrected) new benchmark rate path going forward.
Differing Views on the Inflation Dynamic
There was, it must be said, a hawkish offset to the dovishness in March, in that the projected rates hikes in 2017 and 2018 were kept at the same four hikes a year pace of the December rate plot, albeit starting from the lower 2016 year-end levels. It is also our sense that the dovish caution of March will make a June rate hike all that much more likely for a majority of the Committee, assuming of course the data stays in line with the central tendency forecast.
In part a June move would be to avoid waiting too long between that first and second rate hike, but to a larger extent we suspect keeping a solid consensus in place at so early a stage of policy normalization, makes it more likely than not that Chair Yellen will want to dampen any market fervor the Fed needs to further accelerate the pace of later rate hikes next year, or even later this year.
And the determining factor will be the dynamics of the inflation process through this year. Indeed, while we do expect Chair Yellen to lay out the conceptual underpinnings to the Fed’s policy framework going forward, we also think she may go into what we think is going to be the key policy debate going forward, namely the differences within the Committee on the likely evolution of the inflation process through this year.
For the more hawkishly-leaning Committee members, the “first stirrings” of the long expected rise in inflation is already beginning to show up in the most recent measures of core inflation. In other words, the endlessly debated Phillips Curve is finally showing signs of steepening, with a headline unemployment clearly pushing below its assumed longer run levels, or NAIRU, and in the process underpinning a slow but steady upward pressure on prices and a higher inflation.
In addition, the fierce downward price pressures in the strong dollar and weak oil prices will be steadily dropping out of the data through this year. It will first show in the headline measures that will pop back north, but the shifts in the pressures on goods prices will also then steadily make their way into core inflation, bringing those core measures up closer to the broader service sector inflation that is already running above 3%.
While we are frankly a little baffled by the assertions of a possible April rate hike so quickly out of the gate of the March meeting — and with barely a month’s worth of data to chew on — we suspect it is this more pressing inflation view that is driving the elevated “Watch on the Rhine” messaging for signs of the inflationary pressures.
There are, however, others on the Committee — and a probable majority, Chair Yellen among them one assumes — who believe the recent rise in the core inflation measures was more driven than not by transitory factors that will diminish in the coming months and, more to the point, they still see a much more inertial inflation dynamic in play.
Beyond the time it will take for the dollar and oil effects to work their way into the core inflation measures, for instance, there is an assumption grounded in downward nominal wage rigidity and a pent-up wage deflation still pointing to a slowly moving inflation; that in a slack-based policy framework, rising wage growth will only put a sustained, upward pressures on prices as the last leg of the labor market healing, with the slack around its outer edges tightening up in the part-time, under, and long-term unemployed finally being drawn back into the labor force through the lure of higher wages and training.
But perhaps the real point in the inflation debate we think will be driving the policy debate from here is that the FOMC as a whole seems to agree that the economy is far enough along that how the data unfolds and plays into the forecasts through this year will prove which of the two differing views proves to be the case. And on that front, there may be more of a consensus on the Fed’s pace of rate hikes in response than what the market may be widely assuming.