The December FOMC should be momentous, but perhaps not in the ways the financial markets are anticipating.
What’s at stake
- Following through on an expected hike.
- Further deprecation of forward guidance.
- Outlook for 2019: everyone’s looking for the Fed to provide reassurance, but they might not get much beyond sympathetic noises.
Rate Hike & Dot Plot
- A hike is widely expected and there are numerous reasons to expect the Fed to follow through. With financial markets having grown relatively volatile, it’s hard to see the Fed adding more confusion and uncertainty into the mix. The CME’s Fedwatch tool indicates a market-implied probability of over 75% that the Fed will raise rates by a quarter of a percent. Other points supporting a rate hike also apply to the Fed leaving its dot plot little changed.
- It’s not clear how much the Fed might be concerned about wrong-footing markets that have priced out rate hikes from 2019 and later, all else equal, they would prefer to walk back expectations for rate hikes than be forced to try to reinstate them.
- If the Fed wants to say it is data dependent and not market dependent, then it’ll have to see the data turn before changing their expectations. And the real variables they care about – labor, inflation, and GDP – are still coming in roughly in-line with expectations.
- Finally, the Fed will focus on the transmission mechanism when evaluating financial market conditions. They would have to see market conditions deteriorate or tighten enough to credibly threaten real economic activity. Yet with what we've seen so far, the markets could turn quite quickly if the Fed passed at the December meeting, and then what would the world look like? The Fed would look like it got played, not that it wisely chose a path of moderation or heroically saved the day. The Fed has other tools at its disposal than just a pass, and policy makers would be wise to work through them first.
- While the 2019 median is only two dots away from dipping lower, but the question is which dots. The doves certainly might shift downward in the current environment, but I don't think any of the 5 most hawkish dots are likely to move two or more spots down, in which case it's all about those 4 dots at 3.13% in September. They probably include the so-called troika of Powell, Williams, and Clarida, so much depends on their judgment call. Do they prefer to soothe the market or show they are resolute?
- Arithmetically speaking, both 2020 and 2021 have 9 dots at or above the median, but the 2021 median looks precarious, because more of those 9 dots are at the median.
- For the record, I do believe there's a Powell put. The soft one (open-mouth operations) has already been triggered, but the hard one (actual policy action) is lower. How much lower is the interesting question, but I don’t think we’re there yet. I think the Fed would rather sound dovish than act dovish.
- Not much change here either, although the core PCE inflation projections for 2018 and 2019 might come down slightly, depending on how much the FOMC expects housing prices to weaken and how much feed-through there may be from the decline in oil prices.
- The phrase “further gradual increases” seems like to go after hints in recent Fed communications. This would represent further deprecation of the Fed’s forward guidance tool – yet another step in the normalization process and another way for the Fed to keep some powder dry for easing in the future as necessary.
- Some commentators have suggested the Fed may add to its statement something about evaluating the "lagged effects of reductions in monetary policy accommodation" in order to signal a pause. As with passing on a December hike, this seems premature, at least for inclusion in the official statement. It would not be surprising to hear this phrase bandied about in the press conference, the December meeting’s minutes, or other Fed speak.
- The Fed’s “quantitative tightening” program of reducing its balance sheet contraction is unlikely to see any change. As with removing forward guidance, this is an important part of the normalization programs. One of the secondary benefits is the opportunity for the Fed to get a cleaner read on market prices, which would make the yield curve a more relevant indicator of recession risk.
- As a technical matter, the Fed is likely to adjust the fed funds range in order to avoid any perception that it might be having difficulty controlling short-term interest rates.
- If the official written materials come out as resolute as I suspect, the press conference should come with some sympathetic or dovish noises to soften them.
- Still, in a world of increased political pressure on the Fed, policy makers will emphasize their statutory dual mandate for maximum employment and price stability, and that should lead Powell to emphasize question of the transmission mechanism to the Fed’s policy variables from trade tensions, global growth, and financial market volatility or tighter financial conditions.
- To steady markets it would be helpful to have some sense of R* to anchor expectations. Because Chairman Powell has downplayed the unobservable variables, the debate about current neutral rates versus longer-run neutral has dropped off. Powell may yet come to find that, slippery as they are, the unobservables are unavoidable.