Still Patient

Next week’s FOMC statement and Powell’s press conference will likely acknowledge the meaningful changes in the incoming data since the March meeting but indicate that the FOMC remains in its “patient” stance. ▪ There will continue to be no presumption as to the direction of any future rate adjustments. The FOMC statement will continue to indicate that the FOMC will be “patient” with the next move. ▪ Powell’s press conference is also unlikely to make any waves. He will likely acknowledge that downside risks appear less worrisome and that financial conditions are accommodative, but that soft inflation indicates no need for tightening. He will certainly be pressed on the FOMC’s threshold for rate cuts, but we suspect he will give away little in this regard. 

The FOMC’s primary concern remains to keep the expansion going. On that front, the FOMC will be pleased with developments since the March FOMC meeting. But more soft inflation data ensure there won’t be a shift away from the FOMC’s “patient” stance and back toward considering tightening. 

▪ Despite some gyrations in the data, we now know that real GDP growth, at 3.2%, was robust in Q1, as was job growth. Yes, final private demand growth slowed in Q1, but there is good reason to expect a  pick-up in Q2. The global backdrop doesn’t look as dire, and equity prices have recovered. 

▪ But core inflation, after reaching its objective and staying there for most of 2018, has dipped below 2%  once again. 12-month core PCE inflation likely dipped to 1.6% or 1.5% in March. This dip is earlier and more pronounced than expected. The median projection of 2% inflation this year is now even more difficult to reach. In addition, the measure of longer-term inflation expectations from the Michigan Survey dipped to 2.3%, its lowest level. 

▪ These developments will require a response from the FOMC in the postmeeting statement and from Powell in his press briefing. 

The FOMC will provide additional detail on the maturity composition of MBS reinvestment purchases across a range of Treasury maturities to roughly match the maturity composition of securities outstanding. Policy implementation issues, including IOER and a standing repo facility, will also be considered. ▪ The effective fed funds rate trading closer to its upper bound has prompted speculation as to whether a  

further downward adjustment to IOER is imminent. Our base case is that the Fed would look through current idiosyncratic issues, but an adjustment is possible—or they could leave the option open for an intermeeting move or an adjustment thereafter. 

▪ If reserve scarcity becomes an imminent issue over the next few months, then the Fed could lower IOER,  inject liquidity using open market operations, or even prematurely end balance sheet normalization  (although this is unlikely). 

▪ Balance sheet normalization plans are likely to advance, with greater detail provided by the New York Fed on how exactly they will purchase Treasury securities (from October, to replace MBS principal payments)  to roughly match the maturity composition of securities outstanding, including whether T-bills will once again be purchased. Also, beginning in May 2019, the cap on monthly redemptions of Treasury securities will decline from the current level of $30 billion to $15 billion. 

▪ Discussions will continue on designing a standing overnight repo facility to establish a ceiling for the policy rate and to ensure an abundant supply of reserves. 

Outlook Context 

Tracking the apparent strength of real GDP growth in the first quarter has been like riding a rollercoaster. The early data suggested that growth had slowed quite sharply, perhaps to not much above zero, and a weak  February payroll print raised the question of whether the seemingly unstoppable momentum in the labor growth had come to an end. The foreign data were gloomy, and U.S. equity prices were well off their 2018  highs. And discerning the signal from the noise was complicated by the partial government shutdown, the longest ever, that extended into much of Q1—because of both its uncertain economic impact and its effect of delaying many economic releases. Now we know that real GDP growth, at 3.2%, was robust in Q1, as was job growth. The global backdrop doesn’t look as dire, and equity prices have recovered. But even as some of the questions about the economy’s momentum seem to have been answered, the data have raised other questions. In particular, core inflation, after reaching its objective and staying there for most of 2018,  has dipped below 2% once again. 

Output Growth: What’s the Signal? 

We usually are pretty stubborn with respect to data that disconfirm our forecast as a consequence of following  the first Meyer Rule for Forecasting: “When the data disconfirm the forecast, defend the forecast!” Not only are the data subject to revision, but there are plenty of special factors and noise in any month or quarter. If we are not ready to change our story, we want to be careful about changing our forecast. This principle seems to have been a good guide with respect to the weak data early this year. It’s true that final private demand growth slowed quite sharply in Q1 and that large contributions from inventories and net exports propped up real GDP growth. This suggests that net exports and inventory investment are likely to subtract from real GDP growth in coming quarters. Still, the economy appears to have plenty of momentum into Q2.  Equity prices and consumer sentiment have rebounded, which should be supportive of consumer spending,  and the monthly data suggest a solid trajectory into Q2. Perhaps most important, job growth has continued at a robust pace. We are sticking with a growth forecast quite similar to our last: growth modestly above 2%  in 2019 and modestly below 2% in 2020 and 2021. 

The Labor Market 

Concerns about momentum in the labor market and broader economy have eased. While job gains have been a very uneven month to month, the average monthly pace over the first three months of this year has been very close to what we anticipated in our late-December forecast. And an upward turn in the initial claims data proved to be short-lived. The unemployment rate has surprised somewhat to the upside, and the higher jumpoff warrants some releveling of its projected path. We now expect it to bottom out at a slightly higher level. 

Inflation, Inflation, Where Art Thou? 

Too-low inflation is back at the forefront. From March 2018 through January 2019, 12-month core PCE  inflation was within a couple of tenths of 2%, close enough for the FOMC to say the price stability part of the mandate had been satisfied, even if it wasn’t as clear that it was at 2% on a sustainable basis. But core PCE  inflation has been quite soft in Q1. 12-month core PCE inflation likely dipped to 1.6% or 1.5% in March, a  figure that will be out before Wednesday’s post-meeting statement and press conference. The 12-month rate had been expected to dip somewhat below 2% in mid-year because of base effects, but this dip is earlier and more pronounced than expected. The FOMC’s median projection for core PCE inflation in 2019 from the  March SEP was 2%, already optimistic at that point and now even more difficult to reach. In addition, the measure of longer-term inflation expectations from the Michigan Survey dipped to 2.3%, its lowest level.  While we still don’t expect a change in rates, in either direction, in the near term, these developments will require a response, from the FOMC in the postmeeting statement and from Powell in his press briefing.

FOMC Call 

Risk management and patience given the muted inflation outlook are currently the most relevant  considerations for the FOMC. 

The first consideration may be fading, with the second becoming dominant. But both considerations argue against tightening, and both are likely to remain relevant for quite some time. They underlie our call that there  will be no further rate hikes and that the next move is likely to be a cut, a call that is at odds with the  Committee’s posture, which we’d call “symmetric with a slight tightening bias.” Since early this year, with the funds rate thought to be somewhere close to neutral, participants have moved away from talking about normalizing policy. Instead, participants have generally characterized the policy posture as symmetric,  meaning the next hike could be up or down. Yet the median dots in March still showed one more hike, in  2020. That’s why we describe the Committee’s posture as “symmetric with a slight tightening bias.” There’s still a sense that, downside scenarios aside, some further tightening may be well be warranted down the line. 

Next week’s meeting may provide some sense of how that posture has shifted, though there will be no new dots or macro projections. While substantive changes will need to be made in next week’s statement because of the incoming data, the bigger focus should be on how Powell characterizes the incoming data, the outlook,  and policy during the press conference. Some members have talked about their expectation that a further tightening could become appropriate. But others have been wrestling with whether too-low inflation,  depending on how long it is sustained, might warrant an easing. That now appears more likely to be a trigger for a rate cut this year (not our base case). At next week’s meeting, we’ll be looking for any hints from Powell on how the FOMC is adjusting its outlook in light of the recent inflation data in particular. 

Still Patient 

Since March, policymakers have remarked on having more confidence in the outlook for growth this year,  despite the persistence of downside risks (principally from trade disputes and European economies). Equity prices have fully recovered, and financial conditions in general are quite accommodative. Nonetheless, there isn’t a hint of a return to considering further tightening—far from it. The consensus on the FOMC is that the current policy setting remains appropriate, and it remains to be seen whether any change in the policy setting is warranted. Additionally, the likely lag time means that the effect of the last few rate hikes have yet to be 

fully seen. Growth is above trend, but slowing toward trend this year and next. Inflation is below 2% now but expected to return toward 2% and remain there in 2020 and 2021. The unemployment rate is now likely to fall a little less than earlier expected and, at 3.8%, given observed inflation and the forecast, it sure doesn’t look like an economy operating well below the NAIRU. There’s no impetus to shift away from patience—at least with respect to any potential tightening. 

Focus on Inflation and Inflation Expectations, But Too Early for Insurance Cuts 

Some decline in 12-month core PCE inflation had been expected in the coming months because of base effects.  But a few soft readings in Q1 mean 12-month core PCE inflation likely moved to 1.6% or 1.5% in March, a  figure which will be released by the time of next week’s meeting. That’s a level that some policymakers have hinted could be a threshold for easing. The concern is heightened by the fact that there already appears to have been some erosion of long-term inflation expectations. But we think it’s too early for policymakers to sound the alarm on this basis. We think they likely expect that core inflation readings will firm up over the remainder of 2019, bringing the 12-month rate back toward 2% by the end of the year. 

There has recently been speculation about the possibility of “insurance cuts,” bolstered by references by both  Clarida and Evans. They both favorably cited examples from the 90s. Although inflation expectations are on the soft side and core inflation has disappointed recently, we don’t expect such cuts in the near term. Such insurance cuts are associated primarily with fears of recession or perhaps financial market turmoil. On both of those fronts, concerns have recently eased. While the FOMC’s median projection for core PCE inflation in  2019 of 2% may now appear to be out of reach, FOMC participants likely continue to expect future readings to be firmer than those in the first quarter of this year. They probably still expect inflation in 2019 to end up 

“near” 2%. In any case, we don’t expect Powell to send a pointed signal on this front in his press conference next week. The minutes are likely to provide more detail about how FOMC participants view the recent inflation data, as well as other changes to the U.S. and global economic outlook, as affecting appropriate monetary policy in the months ahead. 

Even If No Near-Term Cuts, Slowing Growth Will Add to an Easing Bias Over Time 

We continue to expect no further rate hikes. And while our base case is that there will be no cut in the near term, we expect that the next move, eventually, will be a cut. Even if inflation does firm up toward 2% by the end of this year, the focus for monetary policymakers will be on slowing growth, specifically the prospect of below-trend growth and a rising unemployment rate. A rise in the unemployment rate, which FOMC  participants project, might seem acceptable given that it would increase the unemployment rate back up toward the median estimate of the NAIRU. But below-trend growth and a rising unemployment rate are clear signs the economy could be slipping toward recession. Given the zero lower bound, we expect the FOMC to be very preemptive with beginning to ease. That is why we expect the next move is more likely to be a cut than a hike. 

The Statement 

We expect all of the changes to the FOMC’s post-meeting statement to be in the first paragraph, which describes the incoming data. In particular, we expect the “patient” language in the second paragraph to remain and for there to be no dissents—though the recent dip in core inflation raises the prospect of a dovish dissent from Bullard. 

Real GDP grew at a 3.2% pace in Q1, faster than in 2018:Q4. We think they’ll describe that pace as “strong”  in the first sentence, which describes “growth of economic activity,” but later noted that household spending and business fixed investment “slowed” in the first quarter. They had previously downgraded the pace of job  gains slightly after the weak February print, from “strong” to “solid.” After the healthy print for March, we  think they could return to “strong.” 

The big question is what they’ll do with the language on inflation and inflation expectations. In the last  statement, they noted that headline inflation declined but that core inflation remained “near 2 percent.” With  12-month core PCE inflation likely to be reported as having declined to 1.6% or 1.5% in March, they will have to adjust that language. In our guess of the statement, we have them taking the simple and direct approach of acknowledging the decline without qualification. The FOMC will then discuss how they’d like  Powell to present that decline at his press conference. 

The language on inflation expectations presents a bit of a conundrum. The language on market-based measures of inflation compensation (“remained low”) still seems appropriate. The Michigan survey measure of longer-term inflation expectations, one of the Fed’s favored measures, edged down from 2.4% to 2.3% in  April, its lowest level ever. That’s notable, but also not inconsistent with “little changed.” Downgrading this language, on top of the expected changes to the language on 12-month core inflation, might be seen as overstating the change in the inflation picture since the last meeting. As a base case, we have them keeping the “little changed” language. The FOMC could also return to lumping together market-based measures of inflation compensation and survey-based measures of inflation expectations, but we see this as unlikely.

Our guess of the May FOMC statement: 

Information received since the Federal Open Market Committee met in March January indicates that the labor market remains strong and but that growth of economic activity has slowed from its solid rate in the fourth quarter. Payroll employment was little changed in February but been rising at a strong rate. Job gains have been strong solid, on average, in recent months, and the unemployment rate has remained low. Recent indicators point to slower growth of household spending and business fixed investment slowed in the first quarter. On a 12-month basis, both overall inflation and inflation for items other than food and energy have declined. On a 12-month basis, overall inflation has declined, largely as a result of lower energy prices;  inflation for items other than food and energy remains near 2 percent. On balance, market-based measures of inflation compensation have remained low in recent months, and survey-based measures of longer-term inflation expectations are little changed. 

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. In support of these goals, the Committee decided to maintain the target range for the federal funds rate at 2-1/4 to 2-1/2 percent. The Committee continues to view sustained expansion of economic activity,  strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective as the most likely outcomes. In light of global economic and financial developments and muted inflation pressures, the  Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes. 

In determining the timing and size of future adjustments to the target range for the federal funds rate, the  Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. 

Voting for the FOMC monetary policy action was: Jerome H. Powell, Chairman; John C. Williams, Vice  Chairman; Michelle W. Bowman; Lael Brainard; James Bullard; Richard H. Clarida; Charles L. Evans; Esther L.  George; Randal K. Quarles; and Eric S. Rosengren. 

Balance Sheet Normalization: Tradeoff between neutrality and flexibility 

If reserve scarcity becomes a pressing issue over the next few months, then the Fed could lower IOER, inject liquidity using open market operations, or even prematurely end balance sheet normalization (although this is unlikely). 

The appropriate level of the IOER rate could be discussed. The past two downward IOER adjustments happened when the (median) effective funds rate was trading persistently at only 5 basis points below the upper bound of the target range (the black line in the chart below). Although the fed funds rate has been trading strong (only 6 basis points below the upper bound) of late, the Fed could conclude that recent strength isn’t evidence of reserve scarcity or tightness but rather of transitory effects related to Treasury auctions and month-end pressures. Going into the next few months, the Treasury’s cash balance is likely to decline, and the debt ceiling will lower the supply of T-bills, which might ease the upward pressure on fed funds. If the  Fed does cut IOER in May, then it will emphasize strongly that it is merely a technical adjustment and not motivated by worries about the macro outlook. It could also prepare markets for the possibility of an intermeeting adjustment.

The FOMC announced in March that it will be conducting Treasury purchases in the secondary market to reinvest MBS principal payments starting in October (subject to a maximum of $20 billion per month). These purchases will be altering the composition but not the overall size of the balance sheet. At least initially, the  Fed will conduct these MBS reinvestment purchases across a range of Treasury maturities to roughly match the maturity composition of securities outstanding. The FOMC is expected to provide more details on these operations in May. 

Also, beginning in May 2019, the cap on monthly redemptions of Treasury securities will decline from the current level of $30 billion to $15 billion, as has been previously announced. 

A major question is what the minimum efficiency level of reserves is. This is difficult to ascertain because there’s a tradeoff between the implicit political costs of a large balance sheet against the benefits of a reduced need to intervene when market conditions warrant. NY Fed researchers concluded that “Having a high supply  of reserves…may have important financial stability benefits that should not be overlooked.” Research and surveys conducted by the Fed system suggested that reserves must stay above $1 trillion, at a minimum.  There are two main elements to this decision: (1) the minimum level of reserves that banks need for a  functioning system, and (2) whether reserves can be provided on an ad-hoc basis (via facilities) or by reducing reserve-draining liabilities (foreign central bank RRP pool). 

A standing overnight repo facility to temporarily convert securities into reserves is likely to be a major topic at the next several FOMC meetings. In a repo transaction, the Fed purchases Treasury securities from a  counterparty subject to an agreement to resell the securities at a later date. Transactions would temporarily increase the number of reserve balances and would help establish a ceiling on the fed funds rate. The presence of such a standing facility would also reduce the demand for reserves since banks could more comfortably hold Treasury securities knowing that at any time they could convert them to reserves. The Fed must decide on how high the offered rate would be, to deter ongoing usage but encourage uptake during stress. Another parameter is whether users would be capped. The New York Fed tested operational readiness for overnight repo in November 2018. 

Once reserves decline to the minimum efficient level (whatever that may be), the Fed must resume net outright purchases of securities. The NY Fed says those purchases will be “gradual and mechanical.” The sizes of those operations will be much larger than in the pre-crisis period. Currency, on average, has grown at a faster rate than nominal U.S. GDP. In nominal terms, it has increased at roughly $100 billion per year, more than twice its pace pre-recession. The market presumes the balance sheet will start growing again (that is, for reserves to stop declining and for net Treasury purchases to resume) in Q3/Q4:2020.

Policymakers have framed the issue of the portfolio’s ultimate composition as a question of whether the duration should be lowered to neutral (same duration as all Treasuries outstanding) or to shorter than neutral.  One benefit of a shorter duration portfolio is the greater ability to remove duration from the market by extending the duration of the portfolio when desired rather than expanding the size of the portfolio (Operation  Twist instead of QE). This likely means adding bills, of which the Fed’s portfolio holds none currently. But there’s no consensus yet. The Fed is assessing how its new participation in the T-bill market could cause T 

bill shortages and disrupt money markets as a result. The New York Fed has already tested its operational readiness to buy T-bills. 

Lastly, if asked, Powell won’t provide any insight into the legal issues regarding “The Narrow Bank,” as a  federal lawsuit is in progress.

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