Fed: Word Play

Published on September 11, 2014

How do you say pretty much the same thing, using different words but without the same loaded meaning and memories, to convey a certain distancing without causing a frightened misunderstanding or excessive reaction?

For all the complexities of the myriad issues on the table when the Federal Open Market Committee sits down for their September 16-17 meeting, its members are likely to spend much of the two days figuratively if not literally flipping through a Thesaurus for the words to update the FOMCs forward policy guidance, whose “time dependent” language is now seen in a rapidly converging view among many Committee doves and hawks alike as being past its sell-by date.

*** The momentum going into next week’s meeting is clearly with a fast-growing number of Committee members pressing for new forward guidance framework that would be more “data-defined” in steering market expectations, and which will almost certainly include a push to drop the “considerable time” language as the last of the time-contingent guidance. It would mark a further evolution in the qualitative guidance introduced in March to supplant the Numerical Thresholds, and like then, would not be intended as a hawkish policy signal per se. ***

*** The “considerable time” phrasing could be eased out altogether which, on balance, is probably more likely and the cleanest of the options before the Committee wordsmiths. It could also be replaced with alternative language less weighed with meaning — take your pick; or for that matter it could still remain for another month, bridged to its more organic end when the bond purchases are finally wound down. But even were it to survive next week, it would be on life support for only another month, as its policy signaling significance is likely to be thoroughly neutralized by the surrounding September statement language or in the post-meeting press conference; it will be fading away, not with a bang but a whimper. ***

*** To be sure, how the market reprices by the time of the meeting will go a long way to defining the final form of the reworked guidance. But the point is that whether the considerable phrasing — and with it, the embedded six month horizon to a first rate hike — comes out this month or next may not matter as much as how it is framed to manage market expectations as well as by the broader trade-offs to get to a Committee consensus that aims, above all else, to maximize the Fed’s much prized policy flexibility when it will matter the most next year. ***

If done gracefully, the changes to the September statement guidance will, in effect, amount to a tactical, policy neutral word play, to get the FOMC relatively painlessly to what is shaping up to be a potentially pivotal December meeting.

The Lure of the Gradualist Guidance Scenario

We suspect these last few weeks that a majority of the FOMC members have been leaning toward a more gradual evolution in the guidance as the base case path. Tweaks to the language here and there would carry them with a maximum optionality to the December meeting, which is probably the earliest moment when the Committee will be judging whether the data warrants a countdown to a rates lift-off.

Under the scenario, the October meeting statement was the more natural setting to ease the “considerable time” language out of the guidance. That the October meeting doesn’t have a pre-set presser could prove a bit awkward, and may have been why the FOMC affirmed in the July meeting Minutes the remaining $15 billion would be wound down in October so there would be little anticipation left on that front.

And in this scenario, the loaded meaning of removing the considerable time language could be pre-emptively dealt with by Fed Chair Janet Yellen in her meet the press after the September meeting.

There is still, in fact, a strong sentiment within the Committee to stick to this safer and perhaps more natural sequencing in the guidance. And that would be especially true if there is any sense by the time of the meeting that removing the apparently combustible “considerable time” language could cause the market to excessively react in a highly undesirable repeat of last summer’s taper tantrum.

It may pay to recall, after all, that it was exactly one year ago this month that the FOMC hesitated on the taper to the open ended bond purchases for fear of not being able to stem even steeper spikes in yields after they had already nearly doubled over the summer.

The lesson learned then was that it is far easier and less costly to be aggressive on dovish side of things than it is to be prematurely hawkish, especially if the calming effect of forward guidance is not especially effective or its sequencing rushed and out of order (SGH 10/1/14, “Fed: Forward Guidance, Fiscal Retrenchment, and the Taper”).

Low Odds of Taper Tantrum Redux

But there are several reasons to believe a redux of last summer’s soaring yields will be unlikely this time around, nor seen as threatening by the Fed policy makers.

For one, the recovery is that much stronger going into the rest of this year compared to where it was in the spring of 2013. Indeed, often overlooked in the focus on the guidance debate is the fairly wide consensus that has taken hold across the FOMC. Whereas in the summer last year the recovery was just gathering steam but still vulnerable to downside shocks — like a fierce tightening in financial conditions and jump in mortgage rates as just one example — economic growth this summer looks to have reached a higher, close to self-sustaining, “near 3%” pace in the wake of the unusual first quarter dip.

And even the disappointing Non-Farm Payroll print last week, somewhat ironically, in fact makes it easier to take the considerable time language out because it lends credence to it not being intended as a hawkish policy signal.

Secondly, the market pricing this time round poses a somewhat different risk scenario. For starters, against the backdrop of that stronger economy and the tactical window opened by the NFP numbers, there is so much cushion in the market’s dovish rate expectations that any misfire in the statement may at worst only bring the market pricing up to the Fed’s own blue dot rate plots.

And what’s more, if the considerable time phrasing is taken out and there is a knee-jerk sell-off that threatens to persist, Chair Yellen can always use the press conference to walk back or qualify any misfires to the new statement guidance.

On the one hand, it is certainly true the market’s rates pricing has persistently run well under even the most dovish of the Fed’s blue rate dot plots displayed in the quarterly Summary of Economic Projections.

But it is not so much that the market is deeply underpricing the Fed’s blue dots as it is ignoring them. Short positions have been repeatedly forced into unwinding at not insubstantial losses when yields unexpectedly fell through this year rather than rise as expected. The dramatic decline in yields seems to have been driven by factors that have little or nothing to do with Fed policy expectations.

Instead, waves of European safe haven buying, foreign central banks, or real money and pension funds rotating into the safety of treasuries have been pulling down the entire curve into short rates as well. Throw in the muscular clout of secular stagnation and lower equilibrium rates forever bond buying, and it is not that very many in the fixed income markets who are willing or able to keep smiling while being beaten black and blue in betting on rising yields with the recovering economy or the approach of eventual Fed rate hikes. These are yield levels no one especially believes in.

Fixed income began in fact to sell off earlier this week, simply on the back of the Federal Reserve Bank of San Francisco’s “Economic Letter” poising the easy to answer question of whether the public might be “misconstruing” the Fed’s rate guidance in expecting a “more accommodative policy” than the FOMC? The answer was obvious, but it was still enough to stoke a market reassessment.

And the market has also been selling off through this week in apparent anticipation the Fed will be adopting a more hawkish policy tilt because the “considerable time” language may be coming out of the statement next week.

Tempest in a Teapot

That, of course, is not the intention of the guidance changes, whether considerable comes out or not, and this kind of knee-jerk market reaction is in fact exactly why many if not most FOMC members want to take the combustible phrasing out altogether as the last of the market moving guidance language once and for all; a tempest in a teapot that makes them long even more for the vagueness of qualitative guidance.

The Fed would not exactly object to a modest upward movement in yields and rates pricing. That in part, would be because a narrowing of the gulf between the market and the Fed’s own rate projections would be lowering the risk of financial instability down the road when it matters the most as rates are finally being raised.

And after all, the intended effects in this evolution of the qualitative guidance is by its nature meant to allow the market to place its bets freely on where it best reads the data: if some in the market put some optionality into the spring, say, for a first rate hike in either March or April, it is hardly inconceivable if the decent data persists through the end of the year; on the other hand, if the secular stagnationists and new neutral investors think far later into 2015 or even into 2016 is the better wager, who is the Fed to object?

That is in fact the very definition of the “policy flexibility” they seek, as they too are closely discerning the trends in the data as they edge that much closer to mandate-consistent levels of unemployment and inflation.

Indeed, however policy neutral by design, the transition to a simpler, pre-August 2011 qualitative guidance will still be directionally hawkish by default in the sense any change in the language to reflect the further progress in the recovery marks another step towards the Exit from the zero lower bound of the last six long years.

Trade-offs to a Compromise Consensus

One last reason the circle is likely to be squared one way or another on the guidance rewrite in September is the broader compromises that may come into play.

The one that looms largest in the minds of a majority of the Committee members is essentially about getting the FOMC to its December meeting (SGH 8/19/14, “Fed: The Minutes, Jackson Hole and into September”). Only after seeing a near full year of the data since the still hard to entirely explain first quarter, and assessing whether the expected developments in the labor market are more clearly showing up in the data would they consider sending a signal that the countdown to lift-off has begun.

The last thing they want to be tied to is the almost artificial six month timeline marked out by the considerable time phrasing that is so explicitly linked to the end of the bond purchases in October. So they too want to move on to a different language in the guidance to get to December from here as much as anyone else, as underscored by Boston Fed President Eric Rosengren’s remarks on the eve of the pre-meeting black-out period.

Getting to a buy-in on the December meeting’s elevated importance may take several routes to a consensus. They could indeed go with the arguments to jettison the considerable time language in September rather than October and rely on the rest of the statement and the press conference to dampen any undesired market reaction.

Or with more far reaching implications, in exchange for a delay in whether to send the policy signal on a rates countdown, they could compromise on raising the prospects the actual first rate hike could come as early as three or four months after the initial signal by compressing the assumed six month run up to the June 2004 rate hike that many on the FOMC see as the most useful template (and which of course is coded into the considerable time language).

To make that a more realistic option, it may also mean the institutional hawks on the Committee who displayed such an aversion to a reliance on the overnight reverse repo facility may have to give way on that front. For all their fears over its excessive use and its impact on the wider market functioning and the Fed’s potentially enlarged role in it, the ONRR does offer a firmer floor under the intended target range for federal funds when rates are finally raised, instead of an elongated scramble to scale up term reverse repos and term deposit facilities to drain $1 trillion or so in excess reserves.

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