Fed Speakers Creating Confusion

The Fed speak has been a tad cacophonous this week. Let’s try to cut through the noise.

Here is a trick learned from many years in the backcountry: When you lose your trail, stop and backtrack to the last place you know where you were. Then start over. In this case, the starting point is the Fed guidance that operationalizes the update strategy:

The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.

There are three conditions for a rate hike: Maximum employment, inflation at 2%, and the expectation that inflation will exceed 2% for some an undefined period. There is a lot of guidance there, but a lot that is left unsaid. We don’t know what inflation would be “moderately” in excess if 2 percent. We don’t know how long the Fed expects inflation to exceed 2 percent. We don’t know even what the Fed will eventually conclude is maximum employment even if we believe that it is something below 4% unemployment.

It’s not just that we don’t know these details. FOMC participants don’t know these details. They have different views of the appropriate interpretation of the guidance. Chicago Federal Reserve President Charles Evans, for example, admits that his willingness to tolerate 2.5% is a minority view of the implementation. They also have different views of when these conditions will be met. Boston Federal Reserve President Eric Rosengren acknowledges that he is particularly pessimistic, saying we would be lucky to reach 2% inflation in 4 years.

All of that is interesting but really only an intellectual exercise. They are false trails. The Fed doesn’t believe they need to lock down any details on an “exit strategy” because the forecasts of FOMC participants indicate that rates will remain at near-zero levels through at least 2023. And that is assuming we get the additional fiscal stimulus that they are pleading for.

Vice Chair Richard Clarida tried to clarify the Fed’s position, telling Bloomberg that the Fed would need to see months of observed inflation at 2% before the Fed would even think about raising interest rates. I would pay attention to Clarida and not get tied up in the forecasts of Fed presidents. Take the FOMC statement at face value; it’s where you go back to when you are lost. The rate story doesn’t get interesting until inflation is 2% on a year-over-year basis and looks to be sustainable for an extended period of time. I have said this before, but it is worth repeating: The risk is not that the Fed decides to hike rates before inflation hits 2%, the risk is that the economy surprises on the upside and brings that outcome sooner than anticipated.

In hindsight, I guess we should have all seen this confusion coming. Federal Reserve Chair Powell had said that they weren’t even thinking about thinking about thinking about raising interest rates. The updated forward guidance gives guidelines about the timing of a rate hike, so they must be thinking of when to raise rates. The Fed thus inadvertently changed the focus of the conversation.

Changing the focus of the conversation toward rate hike is one communications problem. They still have another problem. They left open the question of the pace of asset purchases. Presumably, they could reduce the pace of asset purchases before inflation hits 2%. Moreover, the Fed made explicit that asset purchases were not just about smooth market functioning, but also providing accommodative financial conditions. The implication is that the Fed has retained the option to reduce financial accommodation before inflation hits 2%, but that reduction comes via a slower pace of asset purchases rather than a rate hike.

See the problem there? I don’t know that market participants have fully absorbed that implication. The focus instead has been on the unwillingness of the Fed to commit to additional asset purchases given that its own forecasts reveal we should expect a long period below target inflation. Oddly, Evans makes the case that additional asset purchases are unwarranted until the economy improves. Via Reuters:

Ramping up the Fed’s bond purchases from their currently monthly pace of $120 billion or otherwise beefing up asset purchases would be premature until the economy gets into better shape, Evans told reporters on a call. That could include unemployment closer to 6% than the 8.4% it is now, and more consumers feeling comfortable spending their money outside of the home.

When that happens, “we would have a better idea of the right amount of accommodation and the way to deliver it,” Evans told reporters. “At the moment everybody understands that we are accommodative.”

That sounds like a “pushing on a string” argument, that policy is no longer effective but could accelerate the recovery when the economy gains some self-sustaining momentum. Personally, I have trouble imagining that Fed will actually boost the size of asset purchases if the unemployment rate falls to 6% and looks to be heading lower, but I guess that is just another academic exercise at this point.

The question for the Fed is have they given too much leeway on asset purchases and even interest rates at this point to avoid having to tighten up the guidance with yield curve control or push out asset purchases along the yield curve. I don’t think they are ready for that yet. I am looking for upward pressure on bond yields that appears unwarranted as something that could push the Fed into a more accommodative stance. That or fading inflation expectations. With that in mind, we should be watching an old favorite:

Bottom Line: The Fed is committed to a near-zero rate policy until inflation reaches 2% and anticipates it will remain at or above 2% on a sustainable basis. That is so far off in the future that we shouldn’t get too deep in the weeds before it happens, but now that the Fed has brought up the issue of rate hikes, they are stuck with a new communications problem. Realistically, every time some Fed president puts some conditionality in the Fed’s commitment, someone like Clarida is going to have to come out and lock down expectations again. If they can’t keep expectations locked down with verbal guidance, they are going to have to resort to yield curve control or asset purchases. Yield curve control is the easy route, but the Fed has dismissed it as an option for now. The real risk for rates is not the Fed’s commitment, but the Fed’s pessimism. If the economy continues to surprise on the upside, Fed forecasts will follow.

Powell, Household Wealth, Kaplan

Federal Reserve Chair Jerome Powell reiterated that the Fed is in it for the long haul:

We remain committed to using our tools to do what we can, for as long as it takes, to ensure that the recovery will be as strong as possible, and to limit lasting damage to the economy.

The Fed’s lack of clarity on asset purchases may have caused some market participants to question the Fed’s willingness to maintain easy financial conditions, but Powell is saying that’s not the case. The willingness of the Fed to act is not the risk. The risk is that the economy improves more quickly than anticipated and catches the Fed off-guard. Maybe though not completely off guard. Powell does acknowledge that the economy is showing signs of life:

Economic activity has picked up from its depressed second-quarter level, when much of the economy was shut down to stem the spread of the virus. Many economic indicators show marked improvement.

That said, Powell remains focused on downside risks:

Both employment and overall economic activity, however, remain well below their pre-pandemic levels, and the path ahead continues to be highly uncertain… A full recovery is likely to come only when people are confident that it is safe to reengage in a broad range of activities. The path forward will depend on keeping the virus under control, and on policy actions taken at all levels of government.

That last line refers to the fiscal support for the economy, or the lack of continued fiscal support. Another coronavirus package, which I once thought was political no-brainer, looks very unlikely now that the battle for the next Supreme Court justice is heating up.

Powell attempts to get ahead of any criticism of the Fed’s credit facilities, particularly the Main Street Lending Program:

Many of our programs rely on emergency lending powers that require the support of the Treasury Department and are available only in unusual circumstances. By serving as a backstop to key credit markets, our programs have significantly increased the extension of credit from private lenders. However, the facilities are only that—a backstop. They are designed to support the functioning of private markets, not to replace them. Moreover, these are lending, not spending powers. Many borrowers will benefit from these programs, as will the overall economy, but for others, a loan that could be difficult to repay might not be the answer. In these cases, direct fiscal support may be needed.

Powell is making clear that many firms need grants, not loans, and that is the job of Congress to provide.

In other news, household wealth rose to a record in the second quarter as fiscal stimulus and rising house and equity prices boosted household balance sheets. Wealth is also at a record high as a percentage of personal income excluding transfer payments:

I know that there will be complaints that only the wealthy are better off, but the Fed’s recent report on the Economic Well-Being of Households suggests otherwise. I thought it fairly notable that households broadly believed that they were doing OK financially at the same or better rate than prior to the pandemic:

That’s pretty impressive given the economic hit suffered by many households. Also note the improvement in the percentage of households able to cover a $400 emergency expense with cash:

I guess not only the wealthy saved some of that stimulus money. The broader lesson is that fiscal policy works

Dallas Federal Reserve President Robert Kaplan explained his dissent. Via the Wall Street Journal:

Federal Reserve Bank of Dallas leader Robert Kaplan said Monday the U.S. central bank’s new guidance on the future of interest rates may complicate officials’ future decision making and stoke risk-taking in financial markets.

I don’t find this argument compelling. Tying its hands a little tighter to the new strategy is exactly what the Fed should be doing. Plus, they aren’t tied down by a commitment to QE, so they still retain room to work. In addition, the Fed could always use concerns about financial stability to change the policy stance; the new strategy elevated that option.

On a final note, equity markets have hit a bit of a rough patch. The declines are not sufficient to generate concern from the Fed especially as credit markets appear to be functioning normally. The Fed is arguably relieved for the market to pull back a notch as it will help alleviate any lingering financial stability concerns (looking at Kaplan).

Two Fed Narratives

There are two Fed narratives developing in the background, one that favors a flatter yield curve and another that favors a steeper curve. As of now, it appears that the flat curve scenario dominates the conventional wisdom while the steeper curve is the risk. I think it is worth reviewing the basics of the two scenarios so we can keep an eye on which unfolds in the coming months.

The flat curve scenario is fairly straightforward and quite logical. I say logical because I have defended that scenario multiple times in the past, so it must be logical, right? Here, for example, where I discuss yield curve control and here where I discuss the Fed’s reaction to rising long term yields. The Fed’s update policy strategy and enhanced forward guidance appear generally consistent with this view. The Fed foresees long-term disinflationary pressures as a result of a protracted period of high unemployment. Under the new strategy, the Fed expects to long rates at zero until the inflation reaches 2% to encourage above target inflation and firm up inflation expectations. This was the message delivered in most recent statement and confirmed in the Summary of Economic Projections.

The Fed’s stance appears to favor further policy action to accelerate inflation. As a group, the Fed has steadfastly downplayed positive economic data in favor of a laser-like focus on downside risks to the outlook. Moreover, the median Fed meeting participant does not anticipate inflation exceeding during the forecast horizon that now extends to the end of 2023. That implies the Fed will continue to be pressured to do more to accelerate inflation and the only reason it has yet to do more is lack of time to build an internal consensus on next moves. The easiest, lowest cost next move is yield curve control although the Fed has downplayed that option. The next move is to shift asset purchases to the long end of the yield curve. The threat of these two potential outcomes maintains downward pressure on long term yields.

If the baseline is a flat yield curve, the risk is a steeper yield curve. How do you get there? You get there by recognizing that the Fed’s current policy stance remains dependent on the forecast. The Fed can choose to ignore any potential upside risk to the economy and promise to maintain deeply negative policy rates for the time being, but the rest of us can’t ignore the risk that the Fed gets caught on the wrong side of that bet.

The Fed has gone all in on fighting the last battle. I sense this remains the consensus view as well. The key features of the last battle were a slow recovery, a protracted period of high unemployment, weak wage growth, and persistently below-target inflation. The conventional wisdom and the Fed are deeply attached to that view despite a considerable amount of positive data flow. The Fed’s attachment remains despite the fact that it dramatically upgraded its own forecasts! The dynamics of this recession are very much not like the last and I think it is a mistake to continue to force your forecast into that framework.

Given where the Fed is now, how do we get from here to a steeper yield curve? One path would likely be gradual. Assume the data continues to generally surprise on the upside. That would take the pressure off the Fed to build a consensus to loosen policy further or even make that consensus more difficult to find. The Fed would instead take a policy of benign neglect toward the yield curve. The Fed in this scenario would not deviate from its policy rate strategy but also not step in the way of higher long-term interest rates. If this scenario where to unfold, we would expect Fed speakers to say things like “rising long-term rates reflect an improving growth outlook.” (If instead they say something like “the rise in long-term rates is not consistent with our policy intentions” then they will act to reduce long-term yields. This latter scenario though seems more likely driven by premature expectations of a tapering of asset purchases rather than a data-driven event.)

Another path to a steeper curve could be more abrupt. I focused on this scenario in my FOMC review. The Fed has so deeply embraced the downside risks dominate/this is a repeat of the last recovery framework that they abruptly pivot in a hawkish direction when the weight of evidence to the contrary becomes impossible to ignore. This could mean reducing asset purchases or bringing forward expected rate hikes. Rapid shifts in the outlook are not unprecedented; for instance, the Fed typically dismisses negative economic news prior to a dovish shift.

The key point in all of this is that the Fed’s ultimate policy path will be determined by the forecast. That forecast can change. I think there is a heightened danger that it changes abruptly because the Fed has committed to the pessimistic outlook.

Bottom Line: The baseline scenario is that conditions and Fed policy mesh such that the yield curve remains flat. This is arguably the message from the Fed’s last policy meeting in which the Fed operationalized the new framework. Continued better than expected outcomes are a threat to this scenario. I am sensitive to this risk given that the economy has outperformed my expectations such that it seems clear that this recession does not follow the dynamics of the last.

Fed Doubles-Down on Zero Rates Despite Economic Gains

This was a fairly substantial FOMC meeting. The FOMC doubled down on its near-zero rate policy despite the economic gains of recent months. This was entirely consistent with recently announced changes to the Fed’s policy strategy. In a surprise move, it enhanced its forward guidance such that the guidance is now consistent with the updated strategy. The Fed continues to lean into the downside risks for the forecast, another reason not to doubt their commitment to zero-rates in the foreseeable future.

The primary implication is that the Fed is committing to an extended period of very low and negative real policy rates even as economic activity accelerates. What are the risks here? The first risk is that the Fed retains a lot of leeway to adjust financial conditions via the asset purchase program. There are no commitments to the pace of asset purchases. The second risk is that the Fed has completely left itself open to being blindsided by a better than expected recovery.

The easiest place to start is with the economic projections:

These are substantial improvements in the outlook. The recession is less severe than anticipated and unemployment declines while inflation rises much more quickly. The median rate expectation however remains near zero for another year and now only one FOMC participant expects a rate hike before 2023. These outcomes are entirely consistent with the new strategy as I explained here in Bloomberg and earlier this week in this blog. This is how the new strategy is operationalized.

Despite these improvements, all the Fed see are downside risks:

The path of the economy will depend significantly on the course of the virus. The ongoing public health crisis will continue to weigh on economic activity, employment, and inflation in the near term, and poses considerable risks to the economic outlook over the medium term.

At best, this analysis is starting to sound unoriginal. The Fed remains very, very clearly focused on the last battle. It assumes a long and slow recovery like in the wake of the Great Recession and a complete lack of inflationary pressures. I don’t think we can make these assumptions any more. This isn’t 2007-2009. We don’t know what it is, but we do know that it isn’t 2007-2009. There was nothing wrong with the economy in January. There are no sizable misallocations of investment to overcome. The Fed didn’t let the financial sector crumble. There has been a massive improvement in household finances attributable to fiscal stimulus. And the economy is quickly growing around the virus.

One chart that really screams the difference in the two recessions is the recovery in auto production:

Not to mention housing activity. Builder confidence is at record highs:

I was fairly pessimistic early this year but the facts on the ground are shifting and I think you have to shift with those facts. The Fed is though focused on downside risks and locked into the zero-rate policy path in at least the near term. I think you can describe the near-term path as credibly irresponsible, which is exactly where you want to Fed to be if you want them to let the economy rip.

My preference is to let the economy rip, so I am not going to criticize the Fed. From a macro perspective, it’s a stance that should be positive for risk assets and negative for longer term bonds (the risk on a negative outlook for bonds though is that rising rates push the Fed into more asset purchases on the long end).

The Fed further reinforced the projections with the statement:

The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent. The Committee expects to maintain an accommodative stance of monetary policy until these outcomes are achieved. The Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.

The first part of the reiterates the results of the strategy review. The reference to an inflation average is completely disingenuous because they can’t define a time frame around average, but we all know that at this point. It’s just a game we are playing with the Fed, kind of like flirting. The last part, the commitment to holding rates at near-zero until the economy is both at maximum employment AND inflation is at 2 percent is the unexpected enhanced forward guidance. It is really nothing more than making explicit what the Fed had already made implicitly. This though confirms Fed is locked into its current policy stance until inflation hits 2 percent.

This is all bullish. Run with it, don’t fight the Fed. But watch for things to go sideways. So how can they go sideways? The most obvious place is that while the Fed has committed to a rate policy path, they have not done the same for asset purchases. The Fed can very easily wind down asset purchases and claim to be maintaining accommodative financial conditions. It’s not exactly unprecedented. Moreover, it is now all too easy to see a rapid pivot on asset purchases given that the Fed has so completely embraced the “this is 2010-2018 all over again” scenario. If unemployment and inflation continue to surprise on the upside, the Fed could be caught off guard and want to quickly pull back on quantitative easing. And what if there is a vaccine and in nine months we all book our Hawaiian vacation (yeah, I’m projecting)? That scenario has got to be on your radar as much as the downside scenarios.

Bottom Line: The Fed is committed to zero-rates for the foreseeable future. They are not committed in the same way to the pace of asset purchases. The Fed though is not inclined to shift its current stance very easily. The bar is high for a rate hike. I suspect it is not nearly so high for the Fed to pull back on asset purchases. In the near term, that isn’t going to happen because the Fed is wedded to the bearish risks for the economy. If the forecast changes, the Fed will change with it. But they may be slow to change, and then change abruptly.

FOMC Meeting Not Likely to Deliver New Details

The Fed meets this week, but don’t get your hopes up for big changes in policy or additional details about the Fed’s new “average inflation targeting” strategy. The Fed’s objective is to maintain policy flexibility rather than to commit to a time frame by which to reach the average 2% inflation goal. For the moment, the Fed remains content to simply entrench expectations that the policy path is locked down at zero for the foreseeable future. There are some risks to this strategy.

This is important, so let’s all pay attention: The Fed’s new “average inflation target” strategy is not really an “average inflation target” strategy. Federal Reserve Chair Jerome Powell described it as “flexible average inflation targeting.” What does “flexible” mean? It means the Fed gets to make up the definition of success as they see fit. There is no fixed time frame associated with meeting the target which means the target really isn’t a target. I know some journalist is going to ask for specific details at this week’s press conference, but I very much doubt they are going to get anything more specific out of Powell.

So what then is the benefit of the Fed’s new strategy? It allows the Fed to let inflation run above 2%, something they did not consider an option under the previous inflation targeting strategy. This is an important and meaningful change. It’s particularly important in the context of a recovery that appears more rapid than anticipated. Along with the more rapid recovery is a faster pace of inflation:

And note that the price level looks to be returning to its pre-Covid trend, something you might consider a victory under average inflation targeting:

In the last cycle, we would be looking at those numbers and, in the context of the more rapid than anticipated decline in the unemployment rate, start thinking that maybe the Fed would be shifting into a more hawkish direction. But we aren’t thinking that now. Now we are thinking that there is nothing in the data to prompt a more hawkish reaction from the Fed. We don’t think falling unemployment is by itself meaningful nor do we think inflation at or even modestly above 2% necessarily prompts a hawkish reaction from the Fed. Instead, the Fed is content to allow real interest rates to continue to drop and presumably content to allow them to fall even a notch further than the last cycle:

As long as we all believe this, and the Fed keeps reinforcing it, the Fed doesn’t feel a need to provide more specific details of what exactly is the definition of “average.” There is no point in trying to develop an internal consensus around specifics if you don’t need to.

The Fed’s current strategy is not without risk. I suspect the overarching message from this meeting will maintain the theme that given the loss of fiscal support, the recovery is very fragile and dominated by downside risks such that they laugh at even the idea of thinking about raising interest rates. In other words, the Fed is committed to fighting the last battle, the long, slow recovery experienced in the wake of the Great Recession. The Fed is absolutely unprepared for any outcomes on the right-hand side of the distribution. That opens up the risk that the Fed finds itself pivoting in twelve months or sooner. My general warning is that digging deep into a bearish pit caused many to miss the equity recovery; the same thing could cause us to miss a Fed pivot.

The second risk hanging out there is that the Fed gave itself a “get out of jail free” card by elevating the importance of financial stability in the new strategy guidelines. It and we really don’t know how and when that clause will be enforced. You kind of have to wonder what happens if the Fed’s commitment to maintaining deeply negative interest rates keeps the heat up under risk assets as you might expect it to.

Bottom Line: The odds favor the Fed maintains the status quo at this week’s meeting. It does not appear to have a consensus on enhancing forward guidance nor do I suspect FOMC participants feel pressure to force a consensus on that topic just yet. The general improvement in the data likely removes that pressure. The Fed will likely remain content to use the new strategy as justification for maintaining the current near zero rate path. Powell will continue to lean heavily on downside risks to the economy to entrench expectations that the Fed will stick to that path. The dovish risk this week is that the Fed does surprise with either more specific guidance or an alteration of the asset purchase program to favor longer term bonds. I don’t see a lot of risk for a hawkish outcome unless it was something unintentional in the press conference.