Brainard: More-Than-Modest Downward Revision to Rate Path

Brainard’s speech today revealed that she has made material adjustments to her economic outlook. As such,  she expects fewer rate hikes than she did previously. We see her comments as supporting our baseline call of no further rate hikes. 

It is important to note that she suggested that she has made more than a mere “modest” downward revision to her projected rate path. The “modest” downward revisions to the modal outlook alone warranted “modest downward revisions” to the policy path. However, in addition to marking down her modal outlook, she also saw increased downside risks. She regarded “basic principles of risk management” as indicating that the increase in downside risks would warrant an additional “modest downward revision to the modal path for policy” on top of the modal-motivated revision. So that’s two distinct modest downward revisions. To  underscore this point, she posited that the downside risks alone would warrant a softer path “even if the  modal outlook for the economy were unchanged.” For reference, the last time she gave a formal speech on  policy was in December, when she thought that a “gradual path of increases… remains appropriate in the  near term.”  

She saw economic conditions as satisfying the dual mandate and her focus now is overwhelmingly on  preserving these favorable conditions in the face of downside risks: “the best way to safeguard the gains we  have made on jobs and inflation is to navigate cautiously on rates.” She gave no indication of a presumption that the next rate move would be a hike. When asked, she declined to opine on the nature of any rate  adjustments in late 2019: “From where I am today I think navigating cautiously is the right course, and so I  see the appropriate posture as watchful waiting…I don’t want to prejudge what kind of moves might be  appropriate late in the year, but for now I think it’s important to gather more information on those  crosscurrents while we engage in watchful waiting.” This sentiment echoed Williams’ remarks yesterday:  “Right now the situation is interest rates are right where they need to be. I don’t see any kind of need, given  my own view today and where the economy seems to be heading, to lean one way or the other at this point.”  

She gave little positive news aside from the strong labor market. “Demand appears to have softened against  a backdrop of greater downside risks.” In this vein, she advocated for “watchful waiting,” and stressed that there were “no signs” that inflation is picking up.  

Brainard explained that she had marked down her modal outlook for several reasons and that this change alone would warrant a lower path of rates. The basis for the downgrade was in part the weaker domestic data on spending and sentiment. She singled out the retail sales number, which she had called a “miss.” Even  in stronger areas, such as business investment, there were “some indications of softening there as well.” In addition, she noted that “In the United States, financial markets saw substantial volatility late last year, which may still be affecting sentiment” despite “much of” that tightening has since reversed. 

Outside the U.S., the weaker outlook presented a “crosscurrent” as foreign growth has turned from a tailwind  to a headwind and the slowing has become “more persistent than initially assumed.” Her speech was given almost immediately after, but likely does not reflect, the ECB’s announcement to push back its rate-hike guidance from summer 2019 to year-end and to launch TLTRO-III. Brainard cited downside risks from many  

major foreign economies, including China’s slowdown, spillover effects to Germany and Japan, U.K. Brexit risk, and domestic issues in France and Italy. She noted that dollar strengthening in late 2018 suppressed export volumes and import prices, but recent easing in the exchange rate and long-term rates have eased pressures on EM yields and created more policy space.  

In sum, weaker data in the U.S. and abroad, combined with financial volatility, “warrant a softening in the  modal path for policy.” In addition to a lower modal outlook, the downside risks to that modal outlook have also increased. She listed trade dispute escalation, the U.S. government shutdown, and the upcoming U.S.  fiscal cliff as potentially significant headwinds.  

The asymmetric risks posed by the combination of a low neutral rate and the zero lower bound meant, to her,  the need to guard against inflation expectations falling. Indeed, she noted that the 2019 framework review would include a discussion of temporary price-level targeting. During the Q&A, she noted that average inflation  targeting is “simply at this juncture one of many proposals we may be looking at, so I think it has some merit,  we should look at it, but that is not something that we would be finished addressing until sometime late this  year, maybe beyond that.” Similarly, Quarles noted yesterday that “I myself in advance of that  discussion…view symmetry as meaning we should be as comfortable missing above as missing below, but  we should be aiming for the target.” He took a cautious approach. “I come from the American West. We hunt elk out here. If you miss the elk one foot to the right, you do not respond by missing it one foot to the left.  You should be indifferent as to which direction you miss it because you should be trying to hit it.” 

In her remarks, Brainard discussed the possible factors that might suggest a need for tightening, such as overheating or rising inflation expectations, and explained why each was not a concern currently. Inflation is  “very close” to the 2% objective but she stressed the need for it to reach 2% “on a sustained basis.” She pointed to “underlying trend inflation” as possibly “slightly below” 2%. Furthermore, the flat Phillips curve  suggested “the economy may have room to run” and she dismissed worries of nonlinearities causing rampant  inflation, noting that “all available evidence suggests inflation expectations remain well-anchored to the  upside.” Brainard still had concerns about financial stability, but she didn’t cite these as a reason for tighter monetary policy. Leveraged lending received much attention late last year, and she said it “is one of the areas  of elevated risks that I am watching very closely.” She explained her recent dissenting vote to the Fed decision  to keep the Countercyclical Capital Buffer at zero by saying, “Particularly in an environment as we have today,  where our two main monetary policy goals would seem to call for some watchful waiting on monetary policy,  that counter-cyclical buffer would give us an alternative way of leaning against financial imbalances and  building up a buffer that could be used in a downturn.” 

Balance Sheet Normalization  

As for the balance sheet, she saw it as appropriate to “wind-down” runoff “later in the year.” She reiterated  the reasons for the FOMC’s decision to stay in the floor system and that the fed funds rate is the preferred  active tool “when the fund’s rate is above the effective lower bound.” In her view, an end to runoff “later in  the year” would “provide a sufficient buffer of reserves.” She called for a “healthy cushion” above what is implied from market intelligence. She cited the September 2018 Senior Financial Officer Survey, which implied a figure of $920 billion for reserves. 

On the question of holding MBS vs. Treasuries, she reiterated the preference for an all-Treasuries portfolio.  She said that this shift (from a mixture to only Treasuries) “will be underway naturally, albeit slowly, as these  securities mature and are replaced by Treasury securities.” This wording was a bit odd, as MBS runoff is not being actively replaced by Treasury reinvestment at the moment, although a future policy change could divert those paydowns into Treasury coupons or bills. We suspect that she was simply referring to the ongoing declines in MBS holdings as amounts under the runoff caps are not reinvested. 

As for the maturity and duration aspect of the Treasuries portfolio, she noted the SOMA portfolio’s lack of T bills and much higher weighted-average maturity when compared to non-Fed holdings, which she called “out  of step with common benchmarks.” She thought that, when the Fed “begins once again” to buy Treasury  securities, “it might make sense” to “weight those purchases more heavily toward Treasury bills and other  shorter-dated Treasury securities for a time.” She also argued that it might be beneficial to shift toward  “greater holdings of shorter-term securities to provide greater flexibility,” which is perhaps an allusion to a  policy need for another Operation Twist during a future downturn. But she cautioned that these issues will  be not concluded “for some time.”

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