1) SEP. The FOMC will add two new charts to “show how the balance of participants’ assessments of uncertainty and risks have evolved over time.” The communications objective is to highlight “some of the risk management considerations that are relevant” to policy. They want to shift the spotlight from the modal/baseline to make the risk distribution more prominent. Their latest “Uncertainty and Risks” suggest that their baseline projections overstate the amount of certainty and optimism in the SEP. To highlight “risk management considerations” at this point could provide the basis for–but not the presumption of–further easing.
2) Diffusion Index. One way to summarize the balance is to compress the data into an ISM-style diffusion index to depict the evolution of FOMC participants’ assessments of uncertainty and risks around their economic projections. It is not the only way to do so, though diffusion indices are elegantly simple summary measures and well-accepted practice in general (see BOJ Tankan). The FOMC is relatively small, so minor shifts in views or personnel rotation can be magnified. These indices might not end up being the new SEP charts, but we can use them internally to supplement our own thinking. (Methodology available upon request.)
3) Observations. Clear patterns occur ahead of easing and tightening decisions. Before QE3 ended, uncertainty about inflation eased before uncertainty about output did. The rapid 2008 rate cuts, QE rounds, and the 2019 insurance cuts happened after clear decreases in the index and higher uncertainty. Likewise, decisions to end QE3, lift off, accelerate rate hikes in 2017, and start QT happened when uncertainty ebbed to normal and the balance of risks in each variable returned from negative to neutral.
4) Regime shifts. Before 2014, policymakers were a bit more certain and optimistic about inflation vs. output, but that gap has closed since, with these variables moving together. Concerns about disinflation have intensified since 2012. Another curiosity is how policymakers almost uniformly abstain from ever saying uncertainty is less than the 20-year rolling average; it is always more uncertain than usual.
5) Application. Policymakers currently see the downside risk around the four major variables as very serious. Even during the 2007-2009 recession they saw less downside risk to inflation. They also unanimously see uncertainty as above the 20-year average. This level is all the more unsettling given that the 20-year window is rolling and now includes the elevated-uncertainty period 2008-2013 so current uncertainty could exceed that. Combine that with the increased prominence of inflation projections in the new FAIT strategy and the outlook looks very dour indeed. The amount and persistence of downside risk right now surpasses the severity seen just prior to the start of QE1, QE2, and Operation Twist/QE3. The natural follow-up is to ask how the Fed will use its own remaining levers (balance sheet) or persuade the legislative and executive branches to act quickly.
6) Alternative. They could present the constituent components of the responses to show the dispersion of views on uncertainty and balance of risks. But since Powell said the SEP would add only two graphs, such granularity might be too complex.
7) SEP. Although the levels corresponding to these uncertainties and the balance of risks are relevant, it is quite telling that one can construct a qualitative reaction function from the uncertainties and balance of risks alone. For reference, we included the evolution of projections over time for each variable.