More on Dudley, by Tim Duy: Following up on my piece this morning at Bloomberg, it is worth going into a little deeper detail on New York Federal Reserve President William Dudley’s comments. I think in this interview Dudley is doing a good job explaining policy in terms of the forecast. That is something the Fed needs to keep pushing. It doesn’t sound like the forecast or the risks have moved sufficiently to change the number of rate hikes expected this year. But he sure seems to be leaning toward pulling forward those hikes.
The CNN interview starts hawkish. What does “fairly soon” mean? According to Dudley:
President Dudley: I think it means what it says. It doesn't say it's a week, a month, a couple months. Fairly soon means in the relatively near future…
Quest: And that's obviously fairly soon, which implies sooner rather than later?
Dudley: I think that's fair.
March is sooner than June. May is sooner than June. March is sooner than May. June is sooner than December. Compared to last year, the next rate hike will certainly come sooner in the year. But given the context Dudley must be aware of how his comments would be received.
On the forecast Dudley says:
We've basically been saying that if the economy continues on the trajectory that it's on, slightly above-trend growth, gradually rising inflation, we're going to continue to remove monetary policy accommodation. So let's look at what we've actually gotten. It seems to me that most of the data we've seen over the last couple months is very much consistent with the economy continuing to grow at an above-trend pace, job gains remain pretty sturdy, inflation has actually drifted up a little bit as energy prices have increased. So we're very much on the trajectory that we said -- that we thought we'd be on and we said if we were on that trajectory we're going to gradually remove accommodation.
This is how I how been viewing the situation. The forecast seems pretty much intact, so there seems to be little reason to pull policy hikes forward. But then he adds:
What else have we seen? We've also seen things that should make us even more confident that this is going to continue in the future. After the election we've seen very large increases in household and business confidence, we've seen very buoyant financial markets -- the stock market is up, credit spreads are narrow. And we have the expectation that fiscal policy will probably move in a more stimulative direction. So, put it all together, I think the case for monetary policy tightening has become a lot more compelling.
Three issues are on the top of his mind – confidence measures, easier financial conditions, and fiscal policy. Arguable, these all distill down to expectations of stimultive fiscal policy. While none of these have yet translated into hard data, they have raised the probability of upside risk to the forecast. Indeed, he says this explicitly:
But we do know that fiscal policy is going to move in a more stimulative direction. So what that says to me is that the risks to the outlook are now starting to tilt to the upside. So while I haven't really built it into my GDP forecast, when I think about the balance of risks -- up or down in terms of economic activity -- I think the fiscal side tends to push things -- the risks to the upside.
And raising that upside risk thus makes the case for a preemptive rate hike more compelling.
All of this sounds like a strong push for March. As the interview continues on, however, he seems to walk back his own outlook:
Quest: But you can't wait for it to happen, can you? I mean the whole question of monetary lag. I know you've got to think about many of these policies not coming into force until 2018, but you have to plan now.
Dudley: Well, look, I think monetary policy is pursued on the basis on the economic outlook. Fiscal policy outlook obviously affects that -- the trajectory of GDP, unemployment and inflation. So that's a factor weighing on us but the fact that we have so little specifics yet about what's going to happen -- it's got to wind its way through Congress -- means I don't put a lot of weight on it in terms of my modal forecast. I just think it makes the risks to the outlook a little bit tilted to the upside at this point.
But Dudley said earlier that the case for policy tightening was “a lot more compelling.” So how does a “little bit tilted to the upside” translate to “a lot more compelling?”
What about financial conditions? Surely that demands an immediate response.
Quest: Into this difficult area we have the financial markets. They're on a tear. I mean today could be the 13th record high, we could be in record territory, you know the numbers better than myself. You can't wait for the fiscal plans completely until next year, but you have to take into account what's happening in the markets at the moment, don't you?
Dudley: Well, financial conditions are very important in terms of how they influence economic activity. So if the stock market is up, credit spreads are narrow, financial conditions are more buoyant, that's going to tend to make the economy stronger. The important thing for us, though, is not to overreact to every little movement in the stock market. It's got to be something that lasts for a period of time for it to actually affect household and business behavior. So if the stock market goes up, and then goes right back down, it's not going to have much consequence for the economic outlook. But if it goes up and stays up, then that's going to support, presumably, consumption through higher household wealth.
It important not to “overreact” because there is a lag between the stock market and the real economy. Stocks could head back down. Maybe the Trump rally will fade (but maybe it is less about Trump and more about cyclical improvement). In that case, it would not affect the outlook and thus shouldn’t influence the Fed’s policy decision.
But those confidence surveys, that’s the ticket, right? Well, maybe not:
Quest: What do you believe you're seeing at the moment?
Dudley: Well, there's no question that animal spirits have been unleashed a bit post the election. Stock market is up a lot. Household and business confidence have increased significantly. There's a survey of small businesses that showed a very large increase in December and sustained that increase in January. So, there's no question that sentiment has improved quite markedly post the election.
Quest: That -- animal spirits or whatever you want to call it -- that market influence. It transmits itself around to the entire economy, doesn't it?
Dudley: Well, we would expect to have some consequence for economic activity. But we'll have to see if that actually -- one if the confidence is sustained, and whether it actually materializes in terms of increases in spending. I would say so far we haven't seen much effect of the improvement in confidence actually leading into greater spending. I think the economy is still on about a 2% GDP track, which about what it's been over the last year or so.
So sentiment is a lot better, but it might not hold and even if it does it needs to be felt in the real economy to change the forecast.
Notice that in all three case he emphasizes that those factors have yet to change his forecast. And he downplays the likelihood of those points even translating into something that might change his forecast. So why then does he lead with the case for rate hikes is “a lot more compelling?” It doesn’t sound like it about the number of hikes for him, at least not yet. It is about the timing of the hikes. It seems to have less to do with the forecast itself and more to do with his desire to take preemptive action.
Bottom Line: When I read the interview, it is hard for me to see that he has a strong conviction for drawing forward the rate hike to March. It seems odd to do so if he sees no change in the forecast and downplays the impact of the upside risks. If he does want to move in March, it tells me then it has little to do with either factor and is entirely about staying ahead of the curve. It is about the need for a preemptive rate hike. If his forecast is for three hikes and he wants to hike in March, then his patience has ended and he wants those hikes frontloaded. If for FOMC participants as a whole the forecast has yet to change much, then it is possible that the even if they raise in March, the median projection of three rate hikes this year remains steady.