So I have spent the past day or so trying to get my head around what Yellen and the FOMC were trying to achieve on Wednesday. It certainly wasn’t the massive volatility that followed in the FX market after the announcement and into Thursday. Once again, lack of liquidity and extreme positioning seems to have driven multiple s.d moves in the big currency pairs. But now the dust has settled the main market reaction has been flattening of the curve, with around a 25bp hike taken out by the end of 2017, a marginally weaker dollar and higher equity prices. The latter two will no doubt be welcome by Committee, but less clear that they wanted even lower rate expectations to deliver it.
For the past year or more there has been a large and growing divergence between the FOMC “dots” for rate expectations and market pricing. In simple terms, the FOMC members had felt that once lift-off began, that the hiking cycle would be around half as fast as in 2004, such that rates remained below their long-run level even once the dual mandate had been achieved. The market, on the other hand, saw rates rising even less quickly, and could be argued was consistent with the much discussed “secular stagnation” theory. Rates would have to stay very low due to a structural demand deficiency, in order to meet the inflation objective. In other words, the neutral real rate is still negative and would remain so for at least the next few years (see here for my thoughts on this issue).
In my post before the meeting on Wednesday (here), I said that I didn’t think that there had been sufficient economic news, nor change in rhetoric from FOMC members to warrant a material move down in their rate expectations. That turned out to be wrong. While the much anticipated removal of “patient” from the statement put June on the table for the start of the normalisation process, it was the shift down in the dots that generated the big reaction.
So the median FOMC voter now thinks that rates will rise even more slowly, albeit still somewhat faster than the market expects (particularly further out). When asked at the press conference, Yellen said that the lowering in the dots reflected three things: lower GDP growth projections, lower inflation projections and lower estimate of the long-run, or natural rate of unemployment.
It is worth taking each of these in turn.
On GDP growth, the central projections are around one-quarter of a percent lower in each of the three years. What is odd about that, is that Yellen’s explanation in the press conference was that weaker net export growth was the main factor (o/w the dollar and weaker world growth were the drivers). That makes sense for 2015 and maybe even 2016 (although the multipliers look a bit big to me), but I struggle to see how that works for 2017 as well. Rather, it suggests to me that the FOMC have become worried about the extent to which above trend growth can persist, even with lower rates than they had previously expected. Is this the FOMC starting to come around to the secular stagnation argument??
On the long-run unemployment rate, the downward revision of 15bp is not terribly much, but admittedly does make the starting point for the output gap a little bigger…BUT with the unemployment rate now expected to fall more rapidly, that additional slack is eroded more quickly. So net net, I actually don’t think this is a very big deal at all. (Many commentators are suggesting that this change is the most important thing to come out of the March meeting.)
On inflation, there was a material shift down in expectations for 2015. That is not surprising given the energy shock. But what was more striking to me was the downward move in 2016 and 2017 (something I said I would be looking for in my preview). How does one square it with the revisions to the growth forecast and the change in the dots? The chart below shows how similar the shape over time of the (roughly) two-year ahead inflation forecast has been to the median dots for 2015 and 2016.
This is where the FOMC’s approach to presenting their forecasts gets a bit confusing. Unlike many other central banks, the FOMC do not condition their GDP, unemployment and inflation projections on market expectations for policy, but instead on their own expectations. That ought to mean that, assuming they want to meet their mandate within a two-year horizon (the usual period used by central banks), they should come up with an interest rate path that delivers inflation of 2% and full employment within two years. If they don’t, then the rate path should be adjusted accordingly. In other words, it is the rate path itself that should be the message for the market, not some other confusing combination of factors (as opposed to say, the BoE, where the inflation forecast should be the main message as it implies whether the market expectations are in line with the MPC’s).
Within a reasonable degree of uncertainty, the FOMC have more or less delivered this over the past year or so in their median forecast. But with the inflation forecast now down at 1.7% for end-2016, by which time the effects of the energy shock and stronger dollar should have unwound, maybe the dots should have been lowered even further?
It may be that this meeting is an aberration, and that the global deflationary mentality that currently pervades will abate over the coming months. But the big message I took away from this meeting was that the FOMC are moving closer to the BoE in terms of their message. Rate hikes will be gradual and limited. Maybe not so gradual as the market believes, but clearly a shift in their thinking. They think the time to start is approaching, but they expect the pace of hikes to be slow.
What are the risks to this apparent shift? One is that the headwinds that have pushed against the US economy from the financial crisis are abating more quickly. Yellen said in the press conference that they were receding. If they are truly receding, then the neutral real rate is rising and the Fed will need to start hiking just to maintain the current degree of stimulus. Otherwise growth will accelerate, unemployment will fall faster and wage and price pressures will go up. That would require a more aggressive hiking path to avoid overshooting. Of course this is not far off what Yellen would describe as being a data-dependent approach. What she doesn’t say is that may be the result of a policy error.
Another risk is around financial stability. Nothing looks to be stretched at the moment (apart from govt bonds of course), but there are clearly risks of asset bubbles so long as credit remains so cheap. It is disappointing that since Jeremy Stein left the Committee so little has been said about this topic.
Of course, the risks run in the other direction too. If the secular stagnation crowd are right, then it seems unlikely that the Fed will hike even as slowly as their latest projection.
I am still in the optimistic camp, and so am not a big buyer of the secular stagnation argument. That the Fed is inching that way is interesting, and a challenge to my views. But I still think they will ultimately need to hike more quickly than the market is pricing.