Game On, by Tim Duy: Almost too much Fed news last week to cover in one post.
The highlight of the week was Federal Reserve Chair Janet Yellen's testimony to the Senate and House. On net, I think her assessment of the US economy was more optimistic relative to the last FOMC statement, which gives a preview of the outcome of the March 17-18 FOMC meeting. Labor markets are improving, output and production are growing at a solid pace, oil is likely to be a net positive, both upside and downside risks from the rest of the world, and, after the impact of oil prices washes out, inflation will trend toward the Fed's 2% target. To be sure, some challenges remain, such as still high underemployment and low levels of housing activity, but the overall picture is clearly brighter. No wonder then that the Fed continues to set the stage for rate hikes this year. Importantly, Yellen gave the green light for pulling "patient" at the next FOMC meeting:
If economic conditions continue to improve, as the Committee anticipates, the Committee will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis. Before then, the Committee will change its forward guidance. However, it is important to emphasize that a modification of the forward guidance should not be read as indicating that the Committee will necessarily increase the target range in a couple of meetings. Instead the modification should be understood as reflecting the Committee's judgment that conditions have improved to the point where it will soon be the case that a change in the target range could be warranted at any meeting.
She is under pressure from both hawks and moderates to leave June open for a rate hike, which requires pulling "patient" from the statement. But at the same time, they don't want the end of "patient" to be a guarantee of a rate hike in June. And that is the message Yellen sends here.
More broadly, though, Yellen is signaling the end of extensive forward guidance. They don't know how the data will unfold at this point, so they are no longer willing to guarantee one particular monetary policy path or another. This was also the message sent by Federal Reserve Vice Chair Stanley Fischer. Via the Wall Street Journal:
Mr. Fischer said that while many believe the Fed will move rates steadily higher, meeting by meeting, in modest increments, it is unlikely the world will allow that to happen. “I know of no plans to follow one of those deterministic paths,” he said, adding, “I hope that doesn’t happen, I don’t believe that will happen.”
Instead, Mr. Fischer affirmed that whatever the Fed does with short-term rates will be determined by the performance of the economy, which will almost certainly offer the unexpected.
Mr. Fischer said there is value in making sure you don’t take markets “by surprise on a regular basis.” But at the same time, offering too much guidance can shackle monetary policy makers, and “there’s no good reason to telegraph every action.”
It's "game on" for Fed watchers! Figure it out, because the Fed will no longer be holding our hands.
Separately, San Francisco Federal Reserve President John Williams echoes Yellen's assessment of the US economy. Via the Wall Street Journal:
In an interview with The Wall Street Journal, Mr. Williams expressed a good deal of confidence in the U.S. outlook, especially on hiring. He said the jobless rate could fall to 5% by the end of the year, which means the central bank is getting closer to boosting its benchmark short-term interest rate from near zero, where it has been since the end of 2008.
“We are coming at this from a position of strength,” Mr. Williams said. “As we collect more data through this spring, as we get to June or later, I think in my own view we’ll be coming closer to saying there are a constellation of factors in place” to make a call on rate increases, he said.
He also gives guidance on why the Fed will soon be confident that inflation will trend back toward target. It's all about the labor market:
Mr. Williams said it is likely that the Fed will see a hot labor market that should in turn produce the wage pressures that will drive inflation back up to desired levels. He said much of the weakness seen now in price pressures is due to the sharp drop in oil prices, which he said isn’t likely to last.
“The cosmological constant is that if you heat up the labor market, get the unemployment rate down to 5% or below, that’s going to create pressures in the labor market” causing wages to rise, he said.
Williams also bemoans the failure of financial market participants to, as he sees it, catch a clue:
Mr. Williams said there is a “disconnect” between Fed officials’ and markets’ expectations for the path of short-term rates. He said he hopes that can be bridged by effective communication explaining central bank policy choices.
St. Louis Federal Reserve President James Bullard has often stated the same concern, and does so again in yet another interview with the Wall Street Journal:
Mr. Bullard said he is worried financial markets aren’t fully taking on board the likely path of monetary policy, and are underpricing what the Fed will do with interest rates.
“The market is pricing in a later and slower and shallower pace of increases” compared to what central bankers think, the official said. “The mismatch has to get resolved at some point, and I think there’s some risk it could be resolved in a violent way,” which he suspects no one would like to see.
Similarly, New York Federal Reserve President William Dudley warns that the Fed will need to choose a more aggressive rate path if financial market participants don't figure it out after the Fed starts raising rates:
As an example, one significant conundrum in financial markets currently is the recent decline of forward short-term rates at long time horizons to extremely low levels—for example, the 1-year nominal rate, 9 years forward is about 3 percent currently. My staff’s analysis attributes this decline almost entirely to lower term premia. In this case, the fact that market participants have set forward rates so low has presumably led to a more accommodative set of financial market conditions, such as the level of bond yields and the equity market’s valuation, that are more supportive to economic growth. If such compression in expected forward short-term rates were to persist even after the FOMC begins to raise short-term interest rates, then, all else equal, it would be appropriate to choose a more aggressive path of monetary policy normalization as compared to a scenario in which forward short-term rates rose significantly, pushing bond yields significantly higher.
All of which sounds to me like the Fed wants to see the term premium start drifting higher - in other words, the situation is now the opposite of the unintended climb in term premiums during the 2013 "Taper Tantrum" incident.
When will that first hike occur? Far too much attention is placed on that question says Fischer:
He said there has been “excessive attention” paid to the issue of when rates will be lifted, and not enough to attention to what happens with short-term rates once they’ve been boosted off of their current near-zero levels.
That I suspect is correct; I am more interested in how the Fed proceeds after the first rate hike (June still on the table, but I don't know if they will have sufficient data to be confident in the inflation outlook) than the timing of the rate hike itself. Is the Fed really as eager to challenge financial markets as Dudley suggests? I am a little nervous this is shaping up to be a repeat of the Riksbank incident.
Bottom Line: The Fed's confidence in the US economy is driving them closer to policy normalization. The labor market improvements are key - as long as unemployment is falling, confidence in the inflation outlook is rising. The more important message, however, is as the timing of the first rate hike draws closer, the level of uncertainty is rising. And it is not just about the timing of that rate hike. The Fed is sending a clear message that the subsequent path of rates is also very uncertain, and they don't think that uncertainty is being taken seriously by market participants. In their view, financial markets are too complacent about the likely path of interest rates.