The FOMC is set this week to cut another $10 billion from its asset purchase program. The statement itself will most likely point toward additional confidence that the first quarter slowdown was an aberration, and may even point to signs that inflation has bottomed and is headed higher. Both will give the Federal Reserve more confidence in their existing forecasts. The forecasts will likely be very similar to those issued in January, albeit with some modifications. The output forecast may be adjusted to account for Q1 weakness, while the unemployment forecast is likely to be edged down once again. The latter is more important; the expected timing of the first rate hike may be pulled forward slightly. The addition of new board members puts something of a wildcard into play, but my expectation is that if a policy change is brewing, it would more likely to show itself in Federal Reserve Chair Janet Yellen's post-FOMC press conference rather than the statement itself.
Incoming data continues to indicate the extreme weakness of the first quarter - estimates continue to fall, with Goldman Sachs now expecting -1.9% - was temporary. Job growth has proved to be resilient, albeit I still feel it remains fairly restrained. The recent bounce above the longer term trend does not signal to me a sizable acceleration in underlying economy:
Neither does the path of aggregate weekly hours:
Nor the growth of retail sales:
Nor industrial indicators:
The JOLTS report is a little more reassuring with the gain in job openings:
In short, maybe the economy is set to take-off as Joe Weisenthal at Business Insider expects, but my read is a little more cautious. Regardless, the data are sufficient for Federal Reserve members to hold true to the basic outline of their January forecasts. Any lingering thought of delaying the taper is long gone.
Nor do I think that even if the economy does accelerate the Fed will step up the pace of tapering. It is all about the calendar - by the time the Fed is confident that stronger growth is sustainable, the asset purchase program will be almost complete anyway. At best it would impact the size of the final cut - $15 billion in October or $5 billion in December. Little difference in either case. For the most part, when and if stronger growth shows up in policy, it will show up in the form of moving forward the first rate hike and accelerating the pace of subsequent rate hikes.
The question on my mind is the possibility the Fed turns more hawkish in the months ahead even if output progresses along their existing expectation. Even along the tepid pace of growth seen to date, the combination of falling unemployment:
and inflation potentially bottoming out and turning up:
means the Federal Reserve is closer to meeting their stated policy goals, a point made by St. Louis President James Bullard with pictures like this:
And note too that traditional indicators of monetary policy also continue to point higher:
This kind of data will put increasing strain on the underemployment story. To date, the Fed has been committed to that story on the basis of low wage growth:
Increasingly the Fed will be concerned that the balance of risks is shifting from prematurely reducing financial accommodation to concern about falling behind the curve. And that transition may be abrupt - not unlike what we witnessed recently on the other side of the pond. Via Bloomberg:
Mark Carney said rising U.K. mortgage debt may threaten Britain’s recovery as he signaled interest rates might start to rise earlier than anticipated.
While investors don’t see the Bank of England’s benchmark rate increasing until next April, the central bank governor said it “could happen sooner than markets currently expect.” Higher borrowing costs could stretch over-leveraged households and undermine financial stability, he said.
All that said, if such a change were to occur, it will not be in this week's statement. My expectation is that Yellen sticks to the fairly dovish tune she has been singing. If there are clues that the tenor of the tune is changing I think they would be subtle. Watch for any language from Yellen regarding proximity to goals, optimism on the JOLTS numbers, or references to inflation bottoming out and turning higher. These would be hints that the Fed is increasingly concerned of the possibility of falling behind the curve. Such talk would also hint at the possibility that the new Board members seek to edge policy in a different direction.
On the other side of the coin, look for policymakers to make note of geopolitical risk. The mess in Iraq is already pushing oil prices higher, which the Fed should read as more likely to soften the recovery rather than fuel inflation
Bottom Line: My baseline expectation is minimal policy changes this week. Moreover, my baseline remains a still long period of low rates. I think the Federal Reserve would like to hold onto the "low wage growth means plenty of slack and no inflation story" as long as possible. Watch also the geopolitical risk, as that will tend to reinforce the Fed's existing path. Overall, the situation altogether still argues for the first rate hike in the second half of next year. The Fed's low rate story, however, will come under increasing pressure as the Fed gets closer to reaching its policy goals. And that pressure will only intensify if growth does in fact accelerate. That leaves me feeling that the risk to my baseline assumption is that the first rate hike comes sooner than currently anticipated.
