Download Existential Angst

June 8, 2016
Fed Thoughts:
Existential Angst
A remarkable amount of effort at the nation’s central bank is devoted to justify doing
nothing. As evidenced by the 16 footnotes and 12 references of Chairwoman Yellen’s most
recent speech, there is a lot of science involved, with data smoothed, models run, and
inferences offered.1 As tracked by researchers at the Federal Reserve Bank of St. Louis, a
reader of the statements of the Federal Open Market Committee (FOMC) needs a postundergraduate education to grasp the meaning.2
Still, more than economics is needed to understand current policy setting. Based on their
behavior, the nineteen participants in the FOMC process no doubt took their share of
Vincent Reinhart
Chief Economist
French literature and film classes. After all, they are delivering monetary policy firming
with the trepidation and sense of external dread as Yves Montand delivering nitroglycerin
across a mountain ridge in the 1953 classic, “The Wages of Fear.” For those who left arthouse cinemas behind, in the film an evil American oil company needs to get explosives to
a field in a remote part of South America to blow out a well fire. Not wanting to risk their
relationship with their unionized workers, they recruit four outcasts to transport the volatile
material along a rudimentary road. Spoiler alert: Explosions ensue.
Over the past nine months, many private-sector forecasts of policy rates have similarly
blown up as official assurances that firming was in the cards tapped out. Also similarly
to the film, the experience has raised existential angst among investors as the random
blows of fate accumulated. A scare in China evens GDP growth tracked above 6%? A
referendum looming in a country making up 6-3/4% of global GDP? Disappointment about
a component of the employment report that has a 90% confidence interval of 230,000
workers? These were enough to stop the FOMC truck in its tracks along the gradual incline
of its rate guidance.
Understanding why Janet Yellen grips the steering wheel so tightly is part about
economics and part about policy committee dynamics.
1
http://www.federalreserve.gov/newsevents/speech/yellen20160606a.htm.
2
The research is available here https://reserch.stlouisfed.org/publications/es/14/ES_23_2014-11-05.pdf.
2
In the Standish economic outlook, US real GDP growth bounces about in a channel centered at
1-3/4%. Data on real GDP growth are inherently volatile, so sometimes readings are at the low end
of the channel, such as the paltry 0.8% expansion in the first quarter, and sometimes at the higher
end, such as the 2-1/2% tracking estimate for the ongoing quarter. Expansion at 1-3/4% is both
dispiriting for the nation and likely a touch above trend. Even so, with an aging population
growing slowly and productivity stuck in a rut, resource slack will erode and inflation creep up. The
It would not take
much handwringing
about the
outlook from the
committee’s leader
to cast doubt about
the Fed’s resolve
regarding an
upcoming meeting...
sad news on the growth of the labor force and output per hour also pulls the real federal funds rate
expected to prevail in the long run below its historical average, to 1 to 1-1/4%.
In our forecast, full employment and inflation moving toward the Fed’s goal extracts
tightening from a reluctant FOMC leadership, which ultimately plans to level the nominal fed
funds rate at around 3%.
The incline to their rate guidance is shallower than last year both because policymakers are resigned
to a lower terminal federal funds rate and wary of following a more aggressive path after the market
reaction to their December move startled them.3 That is, in response to greater uncertainty about
the effects of their policy through financial markets to the economy, they scaled back their guidance
from four to two quarter-point hikes in 2016. This concern about the financial market reaction to
their action also explains their reticence to embrace the alternative strategy of waiting until they
see the whites of inflation’s eyes to tighten. Such a strategy, similar to the “optimal policy” path that
Chairwoman Yellen espoused earlier, requires moving quickly and by a substantial amount in the
event, which might pose an outsized risk to policymakers that are unsure about the reception of any
move in markets.
Group Dynamics
The policy pronouncements of Janet Yellen over the years—as an academic, a Fed Board
governor, and a Fed president—placed relatively more weight on unemployment than inflation.
Unconstrained, the chair would probably sound like Fed Governor Lael Brainard.4 Janet Yellen
may have her own individual policy preferences, but she also has the responsibility of herding
a disputatious committee with many participants that do not share her policy preferences. In
such circumstances, the chair’s biggest headache is that the center might not hold if policy
incrementalism felt imposed from the top rather than decided by the group. In the event, it was a
remarkable achievement in group management in March to get the FOMC to agree (mostly) to two
quarterpoint firmings per year.
Still, there is a feature of that path that may tempt Yellen. Spreading two hikes over eight meetings
a year implies an unconditional probability of 25% at any particular one. That is imprecise guidance
for an institution historically desirous of avoiding market surprises. Here lies the temptation: It would
not take much handwringing about the outlook from the committee’s leader to cast doubt about
the Fed’s resolve regarding an upcoming meeting, creating the perception when the meeting comes
that the lack of preparation in markets for action was an overwhelming argument against action.
Chairwoman Yellen wrung her hands about the outlook in her speech in Philadelphia
3
That is the topic of the note, “Fed Thoughts: The House on the Hill”, at https://www.standish.com/us/en/research-and-insights/index.jsp
4
Governor Brainard’s most recent speech on monetary policy cacn be found at http://www.federalreserve.gov/newsevents/speech/
brainard20160603a.htm.
3
(referenced earlier). While embracing the gradual removal of policy accommodation (in line with the
intent of her committee), she characterized the stance as “modestly accommodative” and no longer
mentioned the time frame of “coming months.”
Even more significant, the message the Fed chair read from the employment report was not that
the unemployment rate, at 4.7%, was below the median of all FOMC participants’ assessment of its
natural rate, but that weak net job creation called into question the vigor of economic momentum.
Fed chairs do not often ask rhetorical questions, so read carefully the item on Yellen’s list of
issues, “Or will monthly payroll gains move up toward the solid pace they maintained earlier this
year and in 2015?” This sets the bar for the next action in the near term at the return of net
payroll gains of around 200,000 per month, the earlier average. That is an ambitious goal in an
economy chugging along in a low-growth channel, which, based on the Standish outlook, has about
a three-in-ten chance of eventuating in the June employment report, released about three weeks
after the upcoming FOMC meeting.
Rolling the rock up the hill (another existential reference)
So, in coming months, expect that:
• The FOMC will punt on policy action at its meeting on June 14th and 15th, for all the reasons
we expressed back in April (here). Even a small chance (and it is more than small) of being wrongfooted by the results of the UK referendum is too much of a risk for the Fed to bear.
• Policy makers will express a willingness to firm at future meetings, but with less of a sense of
urgency than had May payrolls met expectations.
• The Summary of Economic Projections will extend the pattern of a flattening of the path of
expected rates exhibited over the history of the “dot” chart (which we discussed here).
In the press conference, the tone of which will be repeated in the semiannual testimony one week
later, Chair Yellen will embrace in a somewhat timeless manner the incremental removal of modest
policy accommodation. We believe Fed may even pull the trigger at its July meeting in the onein-three chance a high-enough reading on payrolls prints. If not, the probability weight on
two hikes gets shifted to September and December and trimmed some in aggregate because
tightening that are deferred may not come.
All that, of course, assumes that the data runs the course laid out in our latest outlook and that
Janet Yellen does not succumb to the temptation of talking tightening out of the market through
the tone of her remarks even as she mouths the words of the group that accommodation must be
removed. The former is about the vagaries of forecasting, with a standard confidence band about
our outlook suggesting that there is a one-in-three chance that there will only be one or no rate
hike this year. The latter is about Janet Yellen. Putting off until tomorrow what the group wants may
mean she runs out of tomorrows—i.e., the Fed get behind the curve of an inflation resurgence, or
that her group runs out of patience. Inflation does not seem the immediate risk, but the drama of
last September onward suggests that the quietude of her group is more an issue. Her safer path is
to lock in a glacial path of the removal of policy accommodation by actually removing some soon,
so as to buy time to define subsequently just how “modest” is remaining accommodation.
The Fed may pull
the trigger at its
July meeting in the
one-in-three chance
a high-enough
reading on payrolls
prints.
4
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WP/June 2016/6-9-16/BR
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