Fed: When in Doubt, Move the Pawn

Published on September 14, 2015

During our days on the High School chess team (don’t ask), our coach always advised when uncertain, be cautious and move the pawn. Coach Stocker’s advice has been on our minds all weekend as we thought through our sense since the pre-meeting black-out began of where the Federal Open Market Committee consensus is likely to come down by the end of their pivotal September meeting this Thursday afternoon.


*** There was a fairly robust FOMC consensus going into last month for a September rate hike, a consensus that had been building since at least March. Its momentum has clearly stalled since mid-August in the wake of the uncertainty over China’s growth outlook and the prospect of new disinflationary pressures, and whether the market volatility is signaling an underlying weakness that will make its way into the US. That uncertainty in our view has probably reduced the odds of a Thursday rate hike to barely even — essentially a low level conviction call — albeit with a near certainty the FOMC remains determined to raise rates before year-end. ***


*** The FOMC decision is likely to come down to one of two cautious “pawn” moves. We suspect the FOMC is still leaning slightly towards a “dovish hike” softened with messaging on a likely gradual trajectory that pushes a second rate hike into next year. An alternative “hawkish hold,” hardened up by strongly signaling a rate hike still looms, carries near equal merit. Ultimately, the decision may tip on which of those paths offers the most optimal messaging framework, and the latter may risk a prolonged policy uncertainty and as much or more risk of market volatility that in any case will greet a first rate hike whenever it comes. ***


*** The Committee decision may ultimately be Chair Janet Yellen’s call. We suspect her more risk averse instincts are probably to wait a bit longer for more clarity on the near outlook and to better prepare a messaging path to a rates lift-off in either October or December. Equally, however, Chair Yellen is also very consensus-oriented, and with a certain inertial aspect to the collegial nature of the Committee decision making process, she will be on guard against the risk of the consensus unraveling or seeing the prized policy flexibility in a “sooner” rate move slipping away the longer the delay to policy normalization. ***


Holding the Consensus Together


Several threads will be woven into that closely balanced decision on Thursday, one of which that is often overlooked is the dynamics of the Committee consensus building process.  For one, there is a certain inertial aspect in the collegial culture of the committee ???decision making that can make the long build up in a policy consensus stubbornly hard to reverse or even delay.


The Fed, for instance, has been circling around a rate hike in “mid 2015” since last year and for a Committee majority, they have already delayed a first rate hike being penciled in for the June meeting by at least a quarter until there was more certainty over the first quarter — which in hindsight, was not so bad after all. And since March, when the FOMC abandoned its formal forward policy guidance in the statement — meant to encourage more price discovery in more two way trading on the data — it has been our sense that the Committee consensus was again gathering momentum toward a start to policy normalization with September penciled in as the ideal lift-off (see SGH 3/18/15, “Fed: September and a Shallow Path”).


The cornerstone of that consensus is the merit of the “sooner” thesis — which was affirmed by Chair Yellen in her speech just before her twin Humphrey-Hawkins testimonies in July — that starting sooner in moving off the Zero Lower Bound before there is firmer evidence of rising inflation will better ensure the policy flexibility to move as gradually as needed in the pace of policy firming. That is meant to protect against the risk of needing to raise rates rapidly and getting so far ahead of a slowly rising effective equilibrium interest rate that it derails the real economy, not to mention cratering the markets.


As the labor market continued to tighten through the summer with the steady removal of slack, a parallel consensus to a sooner start to policy normalization was likewise coming together with reluctant doves brought on board with how gradual the pace of the subsequent rate hikes was likely to be to protect against the risk of a policy error in undercutting the recovery, while hawks were kept at bay in that they will finally be getting their move off the zero lower bound, however gradual its subsequent pace may turn out to be.


Yellen, as a master student of the Fed’s collegial culture, has been methodically building on that coming together of views on the start to policy normalization, and she is well aware of how laborious a process it can be to sound out the various concerns and views of the Committee members, always looking for points of agreement or where the consensus can be built.


There is, to be sure, an elevated uncertainty now around September that has wrong-footed the carefully laid messaging run up to the meeting, as well as a wariness whether there is a signal of underlying weakness in the latest market gyrations. We suspect Yellen herself will be equally wary of making a policy error in prematurely moving to raises rates, indeed as scores of other central banks have done in previous years.


But weighing against that is the risk in a delay slowly unraveling that consensus, and on that point, we would not be surprised in the course of the probable phone calls and email exchanges with her Committee colleagues through last week that she was likely to find few “cold feet” or impassioned arguments against a rate hike; for all the academic blogging and World Bank handwringing, in other words, our sense is that the Committee majority is still not too far from where they were going into the Great Disruption of the market volatility and the China storm (SGH 8/11/15, “Fed: China Syndrome”).


Forecast Tweaks


That may become apparent in the revisions to the Summary of Economic Projections prepared for this meeting. Specifically, our sense is that the Fed is not likely to find the data will be all that different going forward from what they will have before them for this September meeting. So waiting for clarity on how the growth in China unfolds or how price pressures look most likely to be playing out by next year may prove elusive.


On the real growth forecasts, for instance, there is unlikely to be any of the slowing China or global growth making its way into the near term real growth projections. Indeed, our sense is real growth in the central tendency forecasts for 2015 is more likely to be nudged up, not down, from the June 1.8%-2% projection.


Any slowing growth in China (for what Beijing policymakers think and are doing, see SGH 9/8/15, “China: New Stability and Stimulus Measures”) or an ebbing global growth are unlikely to reach into US growth enough until before next year to move the Fed’s forecasts; and equally by then, any modest downward China or Asia growth pressures could just as easily end up being offset by Europe slowly finding its feet, or in the stimulus to domestic aggregate demand in the lower oil and energy prices, however cautious American consumers are about spending their energy savings as freely as before.


Indeed, to the point of the Fed’s dual mandate, the September projections for the headline unemployment rate by year-end and in 2016 are likely to be tweaked lower, probably back to the March’s 5.0% – 5.2% central tendency if not lower, and with 2016 year-end unemployment rate almost certain to be marked with an upper 4 handle on its CTF range.


There is, to be sure, still plenty of slack in the labor markets as the underemployed, discouraged or long term unemployed still need to be drawn back into the market. That said, it is not really a viable argument against the start to a very gradual policy normalization since there will obviously be still enormous accommodation in the system to support continued gains in the labor market for some time.


But it is, of course, the projections for core inflation the spotlight is most likely be on. It is going to be very hard for the staff to find upward inflation any time soon, so the odds are tilted strongly to core inflation being marked down these next few quarters.


But here again, at least in 2015, the obvious downward pressure on core prices at present will have to be set against the recent revisions, so there may only be minor downward tweaks from June’s 1.3%-1.4%. The crucial question will be how much core PCE will be marked down in 2016, perhaps to 1.5%-1.8% or that the upward return in PCE inflation back to 2% longer run level may not really show up in the forecast until the new 2018 column.


So, in other words, core inflation is more than likely to dip lower before it rises in most of the staff projections. And at minimum, that will make for bad optics for those within the Committee — still a majority we think — who believe inflation will nevertheless turn higher even if the signs of that turn are nowhere yet to be seen.


The Inflation Debate


If those falling near term inflation projections bear out, which seems likely, the more dovish-leaning Committee members will press their case that hiking when inflation is so low and falling after missing the target for so many years runs a high risk of reinforcing a downward drift in inflation expectations and a very real deflation risk if the recovery falters and drifts into a recession.


What’s more, the lack of any decent evidence of rising wages would also be pointing to a lower NAIRU than the currently assumed 5%-5.2% longer run levels. That said, though, it may be too early for the estimates of NAIRU to be marked down much in the assumptions for this meeting; some staff will be marking theirs down, which will show up in the broader ranges, but we are unsure if it will be by enough or enough of them to significantly move the needle on the central tendency forecasts.


Here again, most of the downward price pressure is being brought to bear in the sharply lower oil prices and the strong dollar effects on imported goods inflation. But however much those downward price pressures increase through the near term, they remain more transitory in their nature compared to the upward pressure put on service inflation in the tightening labor market. And more to the point for an FOMC majority, almost by definition, the oil and dollar effects will be dropping out of the data around this time next year.


Oil and energy prices, for instance, would have to keep falling at the same pace for their impact on costs and goods inflation to continue much beyond next year. And while the strong dollar effects do linger for longer and reach more deeply in second round effects, the same math would apply in that the dollar would have to keep appreciating at a pretty serious pace to significantly dent price measures further out the forecasting horizon than the next few quarters.


And just as the Fed looked through the previous upward rise in oil prices, even if weak prices extended for more than a year, for the sake of consistency if anything else, their policy response to a reversal in oil prices will be the same in looking beyond it to the underlying changes in the price inflation to focus more on the net stimulus to aggregate demand. This is especially the case, as current orthodoxy dictates, if household and business inflation expectations remain firmly anchored.


What’s more, for all the debate and doubt over the Phillips Curve, whether it is flattened or steepening, or whether wages are still a very reliable indicator of labor market tightness, there remains a still robust faith inherent in the Fed forecasting assumptions that as long as the laws of supply and demand still hold, as the labor markets continue to tighten, it will underpin a steady upward pressure on inflation, especially services inflation.


The Phillips Curve does certainly flatten in periods of low inflation and anchored expectations. But it steepens as the economy recovers and balance sheets are steadily repaired, allowing for a resumption of the more traditional interest sensitive transmission channels of monetary policy. As the economy is “normalizing” so must  monetary policy in moving the nominal policy rate higher in line with an effective equilibrium real interest rate that is slowly rising towards its longer run levels the Fed believes is somewhere around 3.5%.


And there is probably no more fierce a defender of the Phillips Curve as a useful conceptual framework in a slack-based forecasting model than Chair Yellen.


The Communications Strategy


In the end, however, there can be little question how finely balanced this decision will be, and the uncertainty over what exactly might lie behind the market volatility, and whether a needed re-pricing or the foreshadowing of even greater headwinds to growth and inflation cannot be easily dismissed or ignored. The question instead then becomes the balance of risk assessment in which policy path offers the least cost to repair if it proves to be a policy error.


And on that score, it is interesting just how much the post-meeting messaging — whatever the decision on rates policy — is likely to be pivotal and in fact, may drive the decision instead of being the follow up discussion.


We do think the decision is narrowly balanced between either a “dovish hike” or the “hawkish hold” — the alternative pawn moves in reaching back to our chess coach’s advice — in which the path that offers the most optimal communications strategy is the one that is most likely to draw the Committee majority to a consensus, a consensus that could come without dissents.


The dovish hike path entails the FOMC pushes ahead with the quarter point increase in the federal funds target range to 25-50 basis points and using the post-meeting press conference to emphasize how cautiously the start to policy normalization is being taken and to the high probabilities of how gradual the initial pace of rate hikes is going to be. Whether explicitly said or not, we suspect Chair Yellen and her FOMC colleagues will lose no sleep if the market interprets her presser remarks to be indicating a low likelihood of a December rate hike.


There is a wave of Fed speakers already being lined up to hit the news wires in the weeks immediately after the September meeting. And at some point through the coming weeks and months, we would not be surprised to see Chair Yellen offer a further elaboration of the conceptual framework she laid out last March in making the distinction between an effective equilibrium real interest rate that is a variable rather than being a fixed value, and which will be slowly moving towards the Fed’s assumed longer run neutral rate, which for now is still somewhere north of 3.5%.


This, we suspect, will be crucial in countering and preventing the potentially self-reinforcing onslaught of bloggers and market commentary that the Fed has made a drastic policy error from being entrenched in market expectations or undermining business and household confidence.


As to a possible, and indeed likely, spike in market volatility — always a bit of a scary scenario for a central banker — there is we sense a view within the Committee that they will just have to push through it, that there will be volatility whenever they hike, and the argument will certainly be made that the wall of skepticism and market volatity will be that much higher the longer they wait. There is, as well, a sense that the “law of unintended consequences” — in this case, the unforeseen effects of weakened  price discovery or misleading signals leading to malinvestments in staying at zero interest rates for a prolonged period —  is entering into the policy calculations to a greater degree than before.


The “hawkish hold” we suspect may look to carry a modestly more difficult communications challenge in that it means every data point, whether a surprise to the downside or upside, is going to elevate volatility, and a prolonged policy uncertainty could begin to chip away at business or even household confidence.


The hawkish hold would entail making October a “live” meeting as a potential backstop to a rate move as soon as the Committee is more comfortable with a first rate move. The Chair could certainly affirm a press conference could be called, if necessary, but due to the internal logistics to organize and prepare for one, the Fed would have to announce it at least a week to ten days before the actual October 28th meeting.


December’s issues with year-end illiquidity can likewise be overcome by a steady diet of signaling a rate hike is nearing, in the hopes the market will so fully price in a hike that when it comes, it is a validation with a minimal market disruption.


We rather doubt that market pricing would work that way, however, and we suspect most of the FOMC do not think so either. The market psychology just does not seem to be working that way these days, especially with such a large part of the fixed income markets still so skeptical a rate hike will ever come, or assuming one and done if it ever does. The Fed will need to do battle with this secular stagnation that seems to be weighing heavily on market sentiment, which also happens to fit neatly into the views of asset managers with massively long bond and credit product portfolios.


There is a certain irony the Fed wanted the start to the first rate tightening cycle in eleven years and after seven years of the Zero Lower Bound to be so well telegraphed that no one could ever be surprised. But when do things ever work out that way? There is almost never an end to uncertainty, just a new one.


And while market pricing has drifted far below anything the FOMC would like to see on the eve of a possible first rate hike, it is hard to say it will entirely be a surprise since everyone on the planet seems to be talking about the whether the Fed will indeed pull that trigger on the start to policy normalization. Move that pawn, Coach Stocker would advise, and get on to the next policy narrative.

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