No Longer Patient… But Still Not In A Hurry KEY POINTS: What will happen at the March FOMC meeting? •
FOMC drops “patient” from its statement and begins to “normalize” guidance By eschewing temporal, calendar-­‐based criteria for forward guidance and restoring the primacy of incoming economic data, the FOMC is essentially normalizing guidance •
So what will the new forward guidance look like? One candidate to replace the current verbiage is the more subjective “reasonably confident” What do investors need to know? •
No rate liftoff until weak and falling inflation reverses course The timing of the first rate increase depends greatly on when core PCE and other measures of inflation bottom out and how sharply they move towards the Fed’s 2% goal •
Is a Fed rate hike on the table for June? Yes, it is. However, with inflation below their target range for nearly three full years – and expected to drift further away over the next few months -­‐ it is not likely the FOMC will feel confident enough to begin normalizing rates by then •
We stand by our call of no FOMC rate hike until December 2015 o We expect price inflation will remain very soft through the summer and into the fall o Asymmetry of risk around the timing of rate hikes means FOMC members are more inclined to err on the side of being extra cautious •
Be especially wary when interpreting March FOMC forecasts With two prominent hawks retiring and not submitting revised forecasts, the March revisions are likely to be especially misleading when compared to December’s Squishier FOMC guidance will contribute to growing market volatility Expect more frequent price swings – especially around the release of key data ______________________________________________________________________________________________________________ •
Shehriyar Antia March FOMC Preview 2 What have we learned since January’s FOMC meeting? •
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February boasts impressive employment numbers The economy sustained its strong pace of job growth with 295K jobs created in the month of February. Indeed, it is the job growth story that is compelling calls for an imminent normalization of interest rate. The U.S. jobs machine continues to chug along, as the four-­‐
month moving average of jobs created remains a very impressive 320K. Meanwhile the unemployment rate continued to edge lower and, at 5.5%, is now at the top of the range of FOMC estimates for “full employment” – the theoretical level at which low unemployment triggers nominal wage growth and inflation. However, wage growth continues to lag Despite the strong data on jobs, growth in wages continues to lag well behind. February data indicate it continues to sputter along at about 2% -­‐ below the 3-­‐4% range seen prior to the recession. While there have been some signs of wage pressures they have yet to materialize in the Labor Department data. •
FOMC keeps their inflation streak alive! The FOMC’s preferred measure of inflation – core PCE deflator – was below their 2% goal for the 33rd straight month. More importantly, nearly all measures of inflation seem to be moving further away from the Fed’s target. Indeed, it is the anemic inflation story that is supporting calls for restraint in normalizing rates. Headline measures of price inflation continue to be depressed by the sharp and sustained drop in energy prices. At just 0.2% in February, headline PCE is poised to join its cousin CPI and turn [email protected] | Copyright 2015 Macro Insight Group | No secondary distribution Shehriyar Antia March FOMC Preview •
3 negative or deflationary. Meanwhile ongoing low energy prices continue to seep into the core inflation numbers and apply downwards pressure. Fed Chair Yellen signals normalization of guidance In the ultra-­‐low interest environment of the last seven years, the FOMC has had to provide explicit and strong forward guidance to ensure markets of their commitment to maintaining accommodative monetary policy well into the future. This guidance was often temporal based. Remember “considerable period”? With the economic recovery well under way, there are now cross currents on the macro landscape: employment is blowing hot, while inflation is blowing cold. It is clear a turning point in policy is approaching and there is a growing range of views on the Committee about timing. Given the dynamic and evolving situation, it stands to reason the FOMC would require greater latitude to base their decisions on the flow of incoming economic data as well as the evolution of their economic forecasts. At her semi-­‐annual testimony before Congress Fed Chair Yellen laid the groundwork for backing away from utilizing calendar-­‐based guidance. She appeared to make normalization conditional on incoming data and the Committee’s subjective interpretation of it: “Provided that labor market conditions continue to improve and further improvement is expected, the Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when, on the basis of incoming data, the committee is reasonably confident that inflation will move back over the medium term toward our 2 percent objective.” At the same time, Chair Yellen was very careful to sever any link between a change in forward guidance and an imminent move to normalize rates: “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.” Other Fed speakers have spoken about the need to wean investors off the expectation that policy makers would describe their plans months in advance as well. Fed Vice-­‐Chair Stanley Fischer, for example, voiced his distaste for explicit forward guidance by stating: “There is no good reason that I can see for us to telegraph every action that we have to take... It seems to me that you unnecessarily constrain yourself.” [email protected] | Copyright 2015 Macro Insight Group | No secondary distribution Shehriyar Antia March FOMC Preview 4 What will happen at the March FOMC meeting? •
FOMC drops “patient” from its statement and begins to normalize guidance By eschewing temporal criteria for forward guidance and restoring the primacy of the latest economic data, the FOMC is essentially “normalizing” guidance. They sent up trial balloons for such a change in the minutes of the January meeting as well as in Yellen’s Congressional testimony. They did this by altering the conditionality around rate normalization from a specific time frame to a more subjective and data-­‐driven approach. Having markets respond with a shrug, as they did, will provide the FOMC the comfort they need to eliminate calendar-­‐
based, temporal guidance and revert back to a more typical posture of data-­‐dependence. With some expectations for a rate move as early as June, the March meeting is a convenient time for such a change. It provides the Chair an opportunity to elaborate more fully on the new framework for guidance at the press conference that follows. •
FOMC will replace its current guidance with something more subjective So what will the new forward guidance look like? One strong candidate to replace the “patient” verbiage is the more subjective “reasonably confident”. This verbiage made appearances in the minutes of the January meeting and in Yellen’s testimony to Congress a few weeks ago as noted above. The limited market reaction to this phrase in both contexts, gives the FOMC assurance that it would not be misinterpreted or cause undue market turbulence. •
Updates to the economic outlook The FOMC will revise their quarterly forecasts for both key economic indicators and interest rates. It is important to note there will be two fewer forecasts submitted at the March meeting compared to December. This is due to the retirement of Reserve Bank Presidents Fisher and Plosser from Dallas and Philadelphia respectively. We expect the following changes in the forecasts: o Sharply reduced headline and core inflation -­‐ Several measures of inflation have moved further away from the Fed’s 2% goal since December’s meeting. o A lower central tendency for longer-­‐run unemployment. -­‐ With February’s unemployment level breaching the top of the Fed’s previous “full-­‐employment” range and few signs of nominal wage growth, it is apparent that the true rate is somewhere below its current level. [email protected] | Copyright 2015 Macro Insight Group | No secondary distribution Shehriyar Antia March FOMC Preview 5 What do investors need to know? •
No rate liftoff until weak and falling inflation reverses course Their dual mandate for monetary policy keeps the FOMC’s focus squarely on full employment and price stability. That means, not one, but two conditions need to be met before rate liftoff can occur. The full employment box is either very close to being checked or was checked off some time ago for most FOMC members. While strong employment numbers certainly reassure FOMC members of the labor market’s sharp improvement, it is no longer the decisive factor. It is the price stability box that has yet to be checked. This is the part of the mandate that keeps FOMC members up at night. However, based on the current trend of anemic inflation readings it does not seem plausible for the FOMC to be comfortable checking off the inflation box any time soon. •
Is a Fed rate hike on the table for June? Yes, it is. With the FOMC adopting a more explicit data-­‐dependent posture to policy making, the possibility of incoming data swaying enough members to take action exists at every meeting beginning with June. However, with inflation below the FOMC’s target range for nearly three full years – and expected to drift further away over the next few months -­‐ it is extremely unlikely there would be sufficient support to begin normalizing rates in this kind of environment. We stand by our call of no FOMC rate hike until December 2015 So when will the FOMC raise interest rates? The timing of the first rate increase depends greatly on when core PCE and other measures of inflation bottom out and how sharply they move towards the Fed’s 2% goal. It has been our longstanding view that there will be no interest rate increase until December 2015. We took this view last summer and were very far out of consensus at the time. Market expectations have slowly converged with our view since then. This view is based on the following two factors: o Price inflation in the U.S. will continue to soften through the summer As noted earlier, our lift-­‐off call is dependent on incoming inflation data. We expect inflation to continue to decline or remain at disinflationary levels through the summer and only turn upward sometime in the fall. Several key FOMC members will likely want to see a sustained upwards trend in inflation before voting in favor of a rate hike. Hence, the Committee will not likely find sufficient support to move forward until December. •
o Perceived cost of raising rates too early is very high Due to the asymmetry of risk around the timing of rate hikes, FOMC members are more inclined to err on the side of being extra cautious when it comes to raising interest rates. [email protected] | Copyright 2015 Macro Insight Group | No secondary distribution Shehriyar Antia March FOMC Preview 6 New York Fed President Dudley was the latest prominent Fed speaker to refer to this directly in a speech just two weeks ago: “I believe that the risks of lifting the federal funds rate off of the zero lower bound a bit early are higher than the risks of lifting off a bit late…. This argues for a more inertial approach to policy." •
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Be especially wary of comparing March dot plots with December! In addition to our usual hesitations around reading too much into the “dot plots” -­‐ the graphical portrayals of participants interest rate forecasts -­‐ the March dot plots are likely to be especially misleading and problematic. With the retirement of Presidents Fisher and Plosser, the March set of dot plots will not include forecasts from two notable inflation hawks on the FOMC. Absent the forecasts of these two staunch hawks, most central tendencies of the Committee’s forecasts are likely to be skewed to the dovish side and apt to misinform investors. As noted above, we are wary of reading much into the dot plots by nature and believe they have poor predictive value. While all participating FOMC members submit forecasts for the dot plots, not all of these members have an actual vote on policy actions. The dot plots may be a good indication of the discussion going on around the table. However, they are not always an accurate reflection of the subset of participants that actually vote. Squishier FOMC guidance will contribute to growing market volatility With the reversion to a data-­‐dependent posture by the FOMC, every release of macro data will influence the market’s view of policy action. Expect more frequent price swings – especially around the release of key data like inflation, employment and wage growth. Investors should expect even seemingly “routine surprises” in incoming data to have a bigger impact on asset prices and rates. •
A data-­‐dependent posture removes certainty and leaves more room for confusion Over the next few months, expect there to be considerable hand-­‐wringing and pontificating about the “muddled” or “conflicting” message the Fed is sending. This mixed message, however, may be a fair and accurate representation of the cross currents in the macro landscape and the range of views about policy action on the Committee. •
What could change our call for an initial rate increase in December? With an FOMC that is now data dependent, it only stands to reason that our FOMC call be more dependent on the incoming flow of data as well. We have identified three risks to our December call: o A meaningful and extended acceleration in nominal wage growth could be enough for the FOMC to initiate a rate increase sooner than we expect. Keep in mind, there was [email protected] | Copyright 2015 Macro Insight Group | No secondary distribution Shehriyar Antia March FOMC Preview 7 already one head fake on this front with a short-­‐lived surge in wage growth at the end of 2014. o A sharp and sustained turnaround in core inflation data could be sufficient for the FOMC to move before we expect them to. Should core prices bottom sooner than we anticipate and wage growth at least hold steady this would be a compelling case for rate liftoff ahead of December. o A shift in perception of the asymmetric risk around lift off timing -­‐ perhaps due to a growing sentiment of financial stability risks around ultra-­‐low rates -­‐ would support normalization earlier than we expect. We will be tuned in for any changes in Fed rhetoric on this issue. [email protected] | Copyright 2015 Macro Insight Group | No secondary distribution