This has to be the most talked about, written about, and telegraphed rate hike in the history of central banks, and so already feeling a bit exhausted by the anticipation, here are three points to make on tomorrow afternoon when at 2pm, it is fair to say, just about the entire planet is assuming that the Federal Reserve will issue a policy statement announcing an increase in the target range for the federal funds rate to 25-50 basis points.
*** First, we doubt, on balance, the FOMC will go all that far towards an explicit guidance in the formal statement of what exactly they mean by a likely gradual ascent in the policy rate. The doves are certainly pressing to set a high bar for the second rate hike, but it is likely to come instead in Chair Janet Yellen’s remarks to the press and especially in the rate dot projections, rather than a dip back into forward guidance in the formal statement. And if there is a dissent or two, which we doubt, it will only lend to the intended “dovish hike” messaging. ***
*** Second, most of the heavy lifting in defining that expected gradual and shallow pace will come in the dot plots, which are likely to show a decent drop across the three years and in the longer run neutral projections. The Fed’s own rate expectations however are still going to be well north of the market’s current pricing, but in the near term the Fed is more concerned about an unwarranted spike in the term premium and yields, and in any case, is fairly confident the market pricing will eventually rise as each of the forthcoming hikes comes nearer, just as they have done in the run up to tomorrow. ***
*** And third, Yellen is likely to use the press conference to drive home at least three takeaways to frame expectations going into the new year: a firm push back against the “one and done” chatter and the anxieties over a credit meltdown or recession; confidence that inflation will indeed show a modest rise on the back of the dollar and oil base effects dropping out of the data, and perhaps a defense of the “sooner and slower” rate path, including we think, that it is also about ensuring financial stability rather than solely pre-empting an inflation threat that, even the hawkish agree, is several years away. ***
And for those who may be wondering about the Fed’s balance sheet policies, which may come up in press questions, we added a brief take on that to the end of this report.
The Policy Statement and Dots
Several of the more dovish on the Committee are pressing hard to insert the gradual phrasing into the formal statement, and to set a high bar for the second rate hike, namely, that unlike the “reasonable confidence” in the forecast for inflation, the FOMC will need to see actual upward movement in the inflation measures to pull the trigger on the second hike.
But we doubt they will get that for several reasons. For one, our sense is that a solid majority of the Committee wants to stay out of the guidance business, the dip back in the October statement notwithstanding, seeing it as a unconventional policy that is now back in the tool kit, along with Large Scale Asset Purchases, for now anyway. Second, they don’t need to firm those assurances even further since the market is still pricing way under the Fed’s likely gradual path; it might be better to save it for later in case there is, for instance, the need to calm the markets down against an upside data shock.
That said, a compromise could still see the gradual phrasing woven into the statement along the lines of some of the descriptions set out in the October meeting Minutes, perhaps stressing the conditional nature of future rates hikes that could come “quicker or slower than the expected gradual pace, depending on the performance of the economy,” or words to that effect.
In any case, the rate dots of the Summary of Economic Projections are likely to do the heavy lifting on the gradual message. As we wrote previously (see SGH 12/9/15, “Fed: Defining Gradual”), it is our sense that the rate dots are going to be coming down in all three years of the forecasting horizon, with the 2016 dots indicating a lean within the Committee towards three rather than four rate hikes that is generally considered the base case path of a rate hike at every other FOMC meeting. In addition, we think the projections for the longer run neutral interest are also likely to come down, perhaps to a median more like 3.3%, which of course, is still well above anything the market is pricing.
And on the possibility of dissents, we likewise doubt there will be any, but if there are, they will be on dovish side of the FOMC and will only serve to reinforce the intended “dovish hike” takeaway of the messaging.
Chair Yellen’s Presser
Unlike September, we suspect Chair Yellen will have a unified Committee of support behind her when she goes before the press tomorrow afternoon, making this one all that much easier to get the intended message across.
Among her most likely takeaways will be an accent on putting a somewhat higher bar to the second and third rate hikes compared to the first rate hike that will be announced tomorrow. That is, she is likely to affirm that the FOMC would like to see clearer evidence in the data that the deflation threat has largely passed and that the long-sought upward turn is underway.
But we think that won’t be all that hard to offer, since she is likely to also place her and the Committee’s faith in the base effects of the low oil prices and the strong dollar dropping out of the data through next year, probably no later than the spring. If the strong dollar should persist, or oil prices should somehow accelerate even lower, that expected removal of the downward pressure goods prices could be delayed. But the eyes of the Fed in any case will be on what they see as the underlying core price pressures of around 1.7% that mostly lies in the service sector prices finally seeing some wage pressure, or in repressed medical costs fading out of the data stream.
Chair Yellen is also very likely to lend support to the gradual and shallow pace of the tightening cycle by noting that because policy has been at the Zero Lower Bound for so long the desired policy normalization in lifting the nominal policy rate will have to proceed cautiously and slowly. The need is to protect against moving too far ahead of an effective equilibrium rate that is itself only rising very slowly, as the economy recovers from the damaging headwinds of the crisis, back towards its longer run equilibrium.
But she will also stress again that monetary policy operates with a lag. That, in turn, is a cornerstone to what we think might be a robust defense of the “sooner and slower” rate path she and the FOMC are about to undertake over the alternative “later and faster” rate path.
They are essentially two different tactical paths leading to the same destination, but with a key difference, namely the former offers more policy flexibility to adjust the pace depending on the real economy, but most of all, it is about managing financial stability in a rate tightening cycle amid a financial system that has accumulated awfully long positions in a lot of illiquid assets.
Prudent risk management suggests taking a long and cautious approach to removing an enormous amount of policy accommodation in the system, but to stay well short of promises in order to ensure some much needed two way trading and higher term premium, without the market repricing all in a few days.
An Appendum on the Balance Sheet
We wanted to add one last comment on the current state of play on the Fed’s balance sheet policy. We doubt the FOMC will be discussing it extensively today or tomorrow, and Chair Yellen may not bring it up unless she is asked in the press conference. We instead think it is more likely to rate high on the agenda in the January meeting when a rate hike is all but ruled out.
But if she is asked, we suspect she will say the FOMC is in no rush to change its current reinvestment policies to keep the balance sheet constant. Our sense is that the Committee wants to see first how it goes in lifting rates up to around at least 1%, and to build up what several Committee members have described as a bit of rate “buffer” before turning to the balance sheet.
So we believe there will probably be no change in the current reinvestment policies until 2017, with an announcement on new intentions not before either the June or September meeting. For now, the most likely reduction in the balance sheet is going to be as mechanical as possible, using the taper as its template, entailing some buying or selling to even out the amount of holdings rolling off each month.
That said, one other reason to put off any announcement on the reinvestments is to keep the balance sheet in their “back pocket” as an alternative or parallel policy tool to adjust the intended monetary accommodation just in case working with rates alone proves problematic.