"I can still imagine circumstances in which at least one policy move could take place, and possibly two.”
—Federal Reserve Bank of Atlanta President Dennis Lockhart
“The man who has no imagination has no wings.”
Another meeting of the Federal Open Market Committee (FOMC) will come and go next week, briefly noted by the media and market participants who will have turned their attention to the Democratic National Convention. The headlines for both are foreordained. Secretary Clinton will be nominated at one and Chairwoman Yellen will keep monetary policy unchanged at the other. And with both, the more interesting drama plays out over the remainder of the year.
For now, Federal Reserve (Fed) officials must be relieved that no bad thing happened. When they last met in June in advance of the UK referendum on European Union membership, they believed that “…it was prudent to wait for additional data regarding labor market conditions as well as information that would allow them to assess the consequences of the UK vote for global financial conditions and the US economic outlook.” 1 In the event, a strong reading on June payrolls lent some confidence that domestic economic momentum had not flagged. Indeed, data have mostly surprised on the upside for a change, with a widely followed tally of releases relative to expectations emerging into positive territory of late. This good news is not all good news in that a positive may owe to a negative: An increasing number of people are coming to the realization that the growth of potential output has slowed in many advanced economies, the US included. A more appropriate understanding that economic expansion will be more subdued makes it more likely that data surprises will not be so one-sided. It also means that people appreciate that there is less economic capacity to work down, sustainable gains in payrolls are decidedly lower than the performance over the prior few years, and the equilibrium real short-rate—to which policy ultimately has to revert—is lower.
The UK referendum did not run to form, though, and financial markets shuddered from surprise. The majority decision to leave the EU prompted a sizable depreciation of the foreign exchange value of the pound, a sell-off in global equity markets, and a drop in many sovereign yields. In the weeks since, the pound sustained much of that loss but capital markets rallied. How do we make sense of this? More importantly, how do Fed officials make sense of this?
Ample precedent suggests that Fed officials use their staff’s large econometric model, FRB-US, to frame their world view. The chart below plots the net change in the three financial linchpins in that model since the beginning of this year, the ten-year Treasury yield, the S&P 500 equity price index, and the trade-weighted exchange value of the dollar. These financial indicators are scaled by their effects on real economic activity in the medium term in that model. To be specific, the weights were chosen so each financial variable has the same effect on the output gap after two years as a 100-basis-point hike in the federal funds rate. The appreciation of the dollar on net this year—2-3/4 percent on the Bloomberg trade-weighted index—represents a tightening of financial conditions equivalent to a half-point firming in the policy rate.2 At the same time, however, Treasury yields declined significantly and equity markets rallied, implying a sizable net easing of financial conditions. As a result, Fed officials have nothing to lean against by keeping policy easy as markets are a tailwind to economic expansion.
Not surprisingly, market expectations of Fed action this year have crept up in recent days. The probability of at least one policy-rate increase by the end of this year inferred from interest-rate futures prices was hit by the double blows of weak published May payrolls and the UK voting surprise in June. By the end of that month, market participants mostly wrote off Fed action for 2016, with some predicting that the next move would be to ease. As the dust settled after “Brexit” and US employment growth rebounded for the month of July, a Fed move was put back on the financial table, but barely. Futures market prices are consistent with about a four-in-ten chance of a 25 basis point increase in the federal funds rate in 2016.
This seems wrong to us. The Standish view aligns better with President Lockhart’s observation at the outset of this note (recognizing that, like the Atlanta Fed president, we will not vote on the FOMC this year). Domestic economic momentum has been reestablished, the UK shock has been distributed through global financial markets with little apparent consequence for the US, resource margins have mostly been eliminated, and inflation is on a modest incline. A 25 basis point higher nominal funds rate, even a 50 basis point higher one, by year end keeps the real federal funds rate negative and monetary policy accommodative even as it reassures investors that the Fed has not mislaid the keys to the monetary-policy-tightening machine.
We think that Chairwoman Yellen accedes to tightening this year because she recognizes that a one-quarter-point hike reminds the world that the Fed is on duty and reassures her colleagues that they are all on the same page. As for timing, Fed planners probably gravitate to December. For the dovish Fed leadership, an action postponed might never happen. Waiting until December gets a free look at the election results, which are surely material to understanding the other sources of policy impetus in 2017 and beyond. Any committee hurt about delaying in September can be salved by reporting in the Summary of Economic Projections that the preponderance of the FOMC prefers a one-quarter point higher policy rate at the end of the year, making the dots matter. After all, if they are willing to publish that, they are virtually contracting on a December move.
There is an alignment of the data stars—strong payroll gains and a further pick-up in inflation—that makes two actions possible this year. Much more likely, the talk before will be about making the September meeting meaningful, not actionable. Fundamental in this call is our view that Fed leadership accepts—even welcomes—an overshooting of the inflation objective.
As for next week, no stretch of the imagination makes that FOMC meeting meaningful. As a result, we risk the censure of the late, great Ali (as in the opening quote) that we are without wings. We are. At best, the FOMC in July will set the stage for September, which sets the stage for December. Next week, acknowledge a better outcome for employment, be impressed at the resilience of global financial markets in the face of a significant shock, and admit that there is little remaining resource slack as inflation, at least by some measures, moves further above the Fed’s goal.
If they do this, as we expect, Chairwoman Yellen’s speech at the Jackson Hole economic symposium will become the next focal point of market attention. The September meeting will matter, but only to establish that they have run out of room for delay and will tighten in December.