Talking about Data Surprises and Balance Sheet Normalization

The discussion of the near-term outlook at next week’s FOMC meeting will be a bit more interesting, given some notable data surprises since the last meeting.  

▪ Although the slowdown in payroll employment gains in March no doubt got the attention of the FOMC,  it is unlikely to have seriously shaken their confidence in the underlying momentum in the labor market. ▪ Growth of real GDP in Q1 was very weak, advancing at only a 0.7% rate, but that repeats a familiar pattern. We see the underlying details as consistent with our expectation of a substantial rebound in Q2. ▪ The sharp decline in the ten-year Treasury yield and the softening of the dollar may suggest somewhat less optimism about the economy among financial market participants. But the rebound in equity markets in recent days may have lessened this concern. 

▪ Perhaps the most policy-relevant surprise was the decline in core CPI in March, which implied that the  12-month increase in core PCE may have dropped from 1.8% in February to 1.6% in March. That would essentially reverse all of the progress back to 2% that had occurred since the end of 2015. 

▪ If the FOMC had been inclined to act at this meeting, these developments would have prompted considerably more handwringing. But for now, they can afford to await more data to assess whether these recent readings will prove transitory or are providing a more troubling signal. 

Our call is unchanged: We anticipate two more hikes this year, in June and September, and we expect a  change in reinvestment policy by the end of this year. 

▪ We are expecting the Fed to exhibit a steadier hand this year on the policy front. They will be reluctant to have their plan for a gradual series of rate hikes derailed by the inevitable blips in the data or by events that do not change the Committee’s views of the underlying fundamentals. They will not be indifferent to the data, just less hypersensitive. 

▪ We assume a total of three hikes this year, which would leave room for the Fed to begin scaling back reinvestment by the end of the year. When they make the change, we think that balance sheet action will substitute for one rate hike.

The Outlook Context 

There is more to discuss at this meeting about the near-term economic outlook than at most recent meetings.  The incoming data, at least on the surface, raise some questions about the underlying momentum in economic activity and the extent of any progress that has been made in returning inflation back to the 2% objective. In our view, the Committee will have a relatively easy time looking through the weakness in real GDP in Q1 and the disappointing reading for March payroll employment. But the March inflation data may present a greater challenge to their prevailing views. The incoming data between this meeting and the June meeting will likely 

be helpful in sorting out signals from noise in the recent readings on economic activity and inflation. But, as much as one might hope otherwise, a few additional data points will not resolve all of the uncertainty,  especially on the inflation front. 

Looking Through the Very Weak Q1 

Although the Committee may not have been especially worried about the weak growth in Q1, given its recurring pattern, participants will expect to see signs of a rebound brewing in the incoming data ahead of the June meeting. They will be focused on the strength of the labor market and on signs that the very soft consumer spending of the first quarter is giving way to stronger readings this spring. We believe that when the dust settles, we’ll still be looking at a 2% economy. Indeed, outside of consumer spending, final private demand was quite strong in Q1: Residential investment advanced at a 14% rate, and business fixed investment advanced at a 9% rate, with investment in structures (22%) and equipment (9%) surging. 

Also Looking Through March Payroll Employment  

No doubt, the Committee has had an even easier time writing off the small increase in payroll employment in  March. After all, the three-month average increase is still 178K, and other labor market indicators, including the very low level of claims for unemployment insurance, point to ongoing strength. That should make them reasonably comfortable about the labor market at next week’s meeting. And, in any event, they will have much more information to consider prior to their June meeting—including two more employment reports. We expect those reports to reassure them that the March report was not signaling any serious loss of momentum in job growth. Moreover, those reports may also shed light on how much of the decline in the unemployment rate will persist going forward, thus potentially requiring some downward shift in their projected path for the unemployment rate in their June projections. That would take the unemployment rate even further below the  FOMC’s median estimate of the NAIRU.  

When You Look Through the March Inflation Data, What Do You See? 

The decline in core CPI in March undoubtedly raised eyebrows, especially as it reduced the 12-month change in this measure by two-tenths to 2.0%. We expect the CPI data to translate into a small decline for core PCE  as well, lowering the 12-month change to 1.6%. If that is indeed the case, the 12-month change in core PCE  will have returned to its level in January 2016—forcing the FOMC to reassess how confident it is that inflation is still on course to return to the 2% objective in a reasonably timely manner. That should be a policy-relevant discussion. But there will be two more CPI reports in hand at the June meeting. (The second CPI report comes  on the second day, decision day, of that meeting!) 

There may be some consolation from the prospect that the 12-month reading for headline PCE inflation is  likely to remain near 2%, allowing the Committee to retain the language in the statement that “Inflation has  increased in recent quarters, moving close to the Committee’s 2 percent longer-run objective.” 

What’s the Story Behind the Drop in the Ten-year Treasury Yield? 

Changes in financial conditions ahead of FOMC meetings can play an important role in policy decisions. But,  to translate those developments into implications for the economic outlook and for near-term policy, one has to try to identify the source of those changes. Since the March FOMC meeting, the ten-year Treasury yield has declined by around 20 basis points. Does this suggest that financial conditions are more accommodative and thus reinforce the need to raise rates? Or is this a reflection of less optimistic expectations about the economy, perhaps reflecting the weaker data on activity and inflation and fading hopes for significant fiscal stimulus?  

We get some guidance from what happened to other measures of financial conditions. In this case, the decline in the ten-year yield was accompanied by a decline in the dollar, widening credit spreads, and, for a time, a  drop in equity prices (which has since fully reversed). That is a pattern we saw after the election, just in reverse! So this suggests the change in financial conditions likely reflected concerns about the soft data and fading expectations for a large fiscal stimulus being enacted this year. However, financial conditions continue to be influenced by non-Fed factors, not least geopolitical risk (from the French election, for example) and the volatile nature of tax reform predictions.  

Global Considerations 

Forecasts of global growth have been revised up, including by the IMF. This provides a bit of reinforcement of the strength of the U.S. economy, but just a little. The first round of the French election substantially reduced the perceived political risk to the euro area and the EU and reduced downside economic risk from potential developments in France and perhaps elsewhere. 

Fiscal Risk 

We call the potential large fiscal stimulus—much larger than we anticipate—a risk to the economy. Whatever one thinks about the possibility of this leading to faster potential growth in years to come, the demand-side effects will be the story in the near term. Given that a large stimulus would push the economy away from full employment and price stability, it would call for offsetting action by the FOMC in the form of a faster pace of rate hike. Of course, the FOMC response will be influenced by the changing composition of the Committee,  raising uncertainty about inflation and the course of monetary policy. 

FOMC Call 

This is not an action meeting. The statement should, nonetheless, offer up the Committee’s interpretation of the incoming data since the last meeting. As such, the wording may leave an impression, one way or another,  about whether expectations for a June rate hike have been diminished by the soft data on activity and the negative surprise on inflation. We expect the Committee will want to choose its words carefully to avoid having the markets lower the probability they assign to a June hike, which now stands near 70%. So, we expect that in the statement they will recognize the surprises, but put them into context and convey a sense to market participants that the Committee still is inclined to hike in June—while emphasizing that the decision will, of course, be data-dependent! For the Committee, this meeting presents an opportunity to make progress on building a consensus about the timing of phasing out reinvestment; its long-run operating framework; the size and composition of a normalized balance sheet; and how to get from here to there. They certainly will not settle all of these issues at this meeting, but these will be the issues under active consideration. 

A Steadier Hand 

Our theme for the FOMC in 2017 is a “return to plan,” where the plan is a gradual normalization of rates and where “gradual” means slow but continuous hikes. In their forecast and in ours, that pace is three moves this year. Of course, they had a similar plan in December 2015, but it quickly got derailed in early 2016. But, in contrast to the situation a year ago, we now see the Committee as wanting to implement policy with a  steadier hand, being more reluctant to be deflected from that plan by blips in the data or events that do not alter their views of the underlying fundamentals and the outlook, which features an economy growing above trend over the next year with declining unemployment and some further progress toward the inflation objective. Their decision to hike in March—on the heels of the December hike, and without surprisingly strong incoming data pushing the Committee to hike—signaled their commitment to normalization. A June hike is important in reinforcing the message that they remain on course. 

But a Little Less Unity 

If 12-month core PCE inflation drops to 1.6% in March, as we expect, remains at that level in April, and appears likely to remain at that level in May, that would undermine the strength of the consensus for three moves this year and for a June rate hike. It would certainly also reduce the market-implied probability of a  June hike. Nevertheless, if the monthly data are consistent with a solid rebound in GDP growth in Q2; the momentum in payroll employment is clear; the unemployment rate stays where it is or falls further, and the  Committee continues to project core inflation reaching 2% by the end of 2018, we expect the FOMC would hike in June. This would be consistent with our expectation that the Committee will follow a steadier path and, in addition, be more forward-looking this year.  

Getting Ready for an Announcement of a Change in Reinvestment Policy  

The consensus has been building for phasing out reinvestment starting later this year. The preconditions appear to be that the FOMC hikes rates further. We are expecting hikes in June and September, in an environment in which the Committee sees solid momentum in economic activity and some firming of inflation.  Under those conditions, the Committee is likely to feel comfortable making an announcement about changes to the reinvestment policy. We expect the Committee to make significant progress on decisions related to how to phase out reinvestment, perhaps whether to smooth even the tapering to avoid the month-to-month volatility in the amount of runoff. We also expect the Committee to have discussions about the long-run operating regime, what a normalized balance sheet might look like and how to get from here to there.  However, we expect the FOMC statement will not contain any indications of such discussions. 

Time to Confront the Substitution Question 

Normalization of the balance sheet entails reversing the effects that asset purchases and maturity extension programs have had on term premiums. And as a consequence, it is a withdrawal of policy accommodation.  In that regard, the reversal of the effects on term premiums has been underway for some time—indeed, since the end of QE3 in late 2014. And most of that reversal will be completed even before the end of reinvestment  [link]. As Yellen noted, based on staff research, the ten-year Treasury term premium is expected to rise by about 15 basis points this year, adding to the withdrawal of accommodation that will have occurred owing to the hikes in rates this year [link]. That leaves the question of how many 25-basis-point funds rate hikes the normalization of term premiums substitutes for this year and next. This is a discussion that has just begun among participants, and we expect that discussion to be an important part of the deliberations at this meeting. 

Message in the Statement 

We expect the only changes in the statement next week to come in the first paragraph. There are two steps to crafting changes in the language in response to the “information received” since the last meeting: First,  recognize what has happened. Second, pick the language carefully, appreciating that the language will send a signal about whether these developments suggest, in this case, that a June hike is more or less likely. We expect the Committee will recognize the slowing in GDP growth, not recognize the March dip in payroll employment growth, and have a nuanced change in the inflation language. 

In this case, if there is a change in the language in the first paragraph of this statement, the theme will be to recognize the change in the data and downplay its implications. The intent is both to indicate that these developments have not altered their expectation of a June hike at this point and that they do not want to disturb the market-implied probability of a hike, now about 70%. 

We expect the Committee to recognize and downplay the slower Q1 growth. In our guess of the statement,  we use the same language they used in the past when faced with the same pattern. We assume they don’t even recognize any slowing in payroll growth; after all, the 3-month average was still 178K. With respect to inflation, we expect them to subtly recognize the weaker 12-month rate of core inflation, but in a nuanced way. We don’t believe they will provide any further guidance on the end of reinvestment. We don’t expect any dissents at this meeting. 

Our Guess of the May FOMC Statement 

Information received since the Federal Open Market Committee met in March February indicates that the labor market has continued to strengthen even as and that economic activity slowed during the winter months, in part reflecting transitory factors. has continued to expand at a moderate pace. Job gains have been remained solid, on the net, in recent months, and the unemployment rate declined. was little changed in recent months. Consumer spending slowed, while business fixed investment firmed and the housing sector improved.  Household spending has continued to rise moderately while business fixed investment appears to have firmed somewhat. Inflation has increased in recent quarters, and is moving close to the Committee’s 2 percent longer-run objective; excluding energy and food prices, inflation was little changed and continued to run somewhat below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance. 

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, labor market conditions will strengthen somewhat further, and inflation will stabilize around 2 percent over the medium term. Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments. 

In view of realized and expected labor market conditions and inflation, the Committee decided to maintain raise the target range for the federal funds rate at to 3/4 to 1 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation. 

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 objectives of maximum employment and 2 percent inflation. 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. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.  However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data. 

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well underway. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions. 

Voting for the FOMC monetary policy action was: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman;  Lael Brainard; Charles L. Evans; Stanley Fischer; Patrick Harker; Robert S. Kaplan; Neel Kashkari; and Jerome  H. Powell.; and Daniel K. Tarullo. Voting against the action was Neel Kashkari, who preferred at this meeting to maintain the existing target range for the federal funds rate. 

Market Response 

We expect the language will be crafted to be neutral with respect to the markets, and we expect they will be successful, more or less. But, as we learned with the last statement, it can be challenging to assess how the markets will respond to any change in the language.

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