Fed Watch: Changing the Course?

Here's Tim Duy's latest Fed Watch:

Nothing like the Fed minutes to liven up the debate! The minutes generated a buzz among bloggers as well as the financial community, with stocks and bonds gaining on news that the Fed may be looking at a pause in the near future. Is this the correct interpretation? Is this one of the little shifts in sentiment that I am looking for? Very possibly the first salvo in the inevitable move toward changing the statement and policy – but I think the Fed still sees plenty of reason to keep raising rates into next year.

The market moving section of the minutes was:

In that context, all members believed it important to continue removing monetary policy accommodation in order to check upside risks to inflation and keep inflation expectations contained, but noted that policy setting would need to be increasingly sensitive to incoming economic data. Some members cautioned that risks of going too far with the tightening process could also eventually emerge…

…Several aspects of the statement language would have to be changed before long, particularly those related to the characterization of and outlook for policy…Participants noted that any forward-looking elements of the statement should clearly be conditioned on the outlook for inflation and economic growth.

The Fed believes in fostering a healthy relationship with markets, which in practice translates into providing clear signals about the path of policy. At the same time, policymakers do not like to be roped into a policy path. And I believe the latter is the current concern on Constitution Ave. When the Fed Funds rate was 1%, there was little question about the path of policy. As long as inflation remained tame, the Fed could remove policy in 25bp increments and rest easy with the markets convinced that they would follow that path. But now that rates have been mostly “normalized” in the neutral range, the fact of the matter is that policy is no longer so straightforward.

Instead, policy is increasingly data dependent. Recognizing this, a growing number of Fed officials believe they need more flexibility – ability to shift without surprising financial markets – to react to incoming data.

The problem is trying to achieve that flexibility. Leaving the language as it is implies the path is set for the next meeting. But changing the message apparently means that the path is set as well – to a pause in the cycle. Market participants might take that to mean not just pause, but done raising rates entirely. Consequently, the attempt to increase flexibility could trigger reduced flexibility in the opposite direction. Something of a conundrum and one that I believe has been a persistent problem with the statement over time.

A problem that is not without a solution, of course. Policymakers could clarify their intentions with Fedspeak. And indeed they have – Mark Thoma reports that Fedspeak remains convincingly hawkish. This suggests that policymakers want to regain flexibility, not necessarily signal a pause in rates is imminent.

Moreover, the staff’s expectation is that the impact of higher energy prices on core inflation fades, this does not necessarily argue for a pause. Why? Because the outlook for growth holds strong. Notably, look at the staff’s forecast (italics mine):

Output growth was expected to pick up in 2006, as the boost from hurricane-related rebuilding activity more than offset the effects of somewhat tighter financial conditions, and then slow in 2007, as the impetus from rebuilding waned.

Growth is expected to accelerate – but Chicago Fed President Michael Moskow claims growth is already above potential and excess slack in the economy has been largely eliminated. Slowing in 2007 is not much comfort to someone worrying about inflationary pressures now. So I don’t sense that he is going to be arguing for a pause in the near future.

Also notice that despite 300bp of tightening, financial conditions are only “somewhat tighter.” This reflects the fact that Fed tightening to date appears to have had minimal impact on the long end of the yield curve. This lack of pass through is likely the reason for the staff’s optimistic outlook despite a long series of rates hikes. If markets take a pause to mean that hikes are over and start looking for a rate cut, financial conditions could loosen back up in a period of what staff expects to be accelerating activity. This appears to be counterproductive given the Fed’s inflation worries.

In short, I think you can focus on the expected “pickup in growth side” or the “risk of going too far” side of the minutes. I will stick to the midpoint of these interpretations: The Fed is increasingly worried that policy is being taken for granted. They want more flexibility in policy, more recognition that incoming data is increasingly important, they need to communicate the possibility of change while sticking to the current path, and convey that a pause does not necessarily mean the tightening cycle is over. Looks like a big communication challenge ahead.

Overall, I am not surprised that officials are ready to revisit their message – but we are still looking for the data and Fedspeak to tell us that more flexibility means a pause. [All Fed Watch posts.]

[Update: See also The End To Measured Pace? by David Altig at macroblog and Inverted yield curve edges closer by Jim Hamilton at econbrowser.]