Fed In No Hurry To Tighten But Still Seeks 'Normalization'
21 April 2017
June Rate Hike Less Likely, But 3 2017 Hikes Still Possible
Policymakers Also Want To Get Started Shrinking Balance Sheet
by Steven K. BecknerIt was always a forgone conclusion that the Federal Reserve would not raise the federal funds rate in early May, but until recently many thought it would move in mid-June. Now that's also in doubt. With the U.S. economy experiencing its perennial first quarter swoon and the post-election "Trump rally" sputtering on Wall Street amid domestic and global uncertainties, speculation has risen that the Fed will delay and/or diminish rate hikes. Well, maybe. It does seem more likely the Fed will postpone raising the funds rate (and other short-term interest rates) past June, but it's too early to conclude it will diverge from the median projection of three total rate hikes for 2017 reaffirmed at its March 14-15 Federal Open Market Committee meeting. Later doesn't necessarily mean less. If the FOMC passes on raising rates at the June 13-14 meeting, it may simply mean those other two rate hikes will come in the second half -- perhaps at the Sept. 19-20 and Dec. 12-13 meetings, both of which will occasion a press conference by Chair Janet Yellen and a quarterly revision of economic and funds rate projections ("dots"). It's also too soon to presume the Fed will indefinitely keep downward pressure on long-term rates by continuing unabated its policy of reinvesting proceeds from maturing Treasury securities and principal payments from agency debt and mortgage-backed securities (thereby preventing any shrinkage in the Fed's $4.5 trillion balance sheet). The timing of rate and balance sheet actions could certainly change, but it would take a lot to significantly alter the course of monetary policy. There is a sizable consensus among Fed policymakers to get on with "normalization" of the funds rate and to get started on balance sheet normalization. After holding the funds rate near zero for seven years, the FOMC majority is eager to get away from the zero lower bound and trim a bloated securities portfolio, in part out of a desire to make room to ease credit if things don't turn out so well. As good an indication as any of the shift in sentiment is the transformation from "dove" to "hawk" of Boston Federal Reserve Bank President Eric Rosengren. He says four rate hikes may be needed this year "to avoid creating an over-hot economy that could require a more rapid tightening of monetary policy." Another erstwhile dove and long-time Yellen advisor, San Francisco Fed chief John Williams also says he "would not rule out more than three increases total for this year." This swing does not mean Fed policymakers collectively have become more aggressive or are bent on accelerating rate hikes. Keeping things in perspective, remember that at the start of 2015 and 2016, the FOMC anticipated four rate hikes, but ended up doing only one due to untoward global economic and financial developments. So, while Yellen denies the Fed is "behind the curve," she and her colleagues feel they are now merely playing catch-up relative to those ambitious projections. When they raised the funds rate 25 basis points on March 15 to a 75-100 basis point target range Yellen & Co. declared "the stance of monetary policy remains accommodative." They had a point. It was just the third quarter point move since the financial crisis. With the Fed achieving "maximum employment" and nearing its 2% inflation target, policymakers feel they can and should get back on a steady, gradual tightening path. Another motive is to avoid the kind of excessive risk-taking that artificially low rates can generate. But they remain cautious. As Yellen says, policy is "not on a pre-set course." The actual pace of rate hikes will depend on the economy's performance, which is taught with uncertainty just now. In any case, while the Fed allows for more rate hikes, as always, it does not plan on making policy truly restrictive. Though persistently ahead of market expectations, Fed rate projections ("dots") are not particularly ambitious. Even if the FOMC raises the funds rate three times each of the next three years, it will only arrive at the estimated 3% longer run "neutral" rate -- a level that has been reduced 125 basis points over the last five years due to slower potential GDP and productivity growth. If the funds rate does creep up to 3%, the real funds rate will only be 1%. The Fed's aim is to sustain, not restrain expansion. As Yellen put it April 10, "Whereas before we had our foot pressed down on the gas pedal trying to give the economy all the oomph we possibly could, (the Fed is) now allowing the economy to kind of coast and remain on an even keel -- to give it some gas but not so much that we are pressing down hard on the accelerator..." In time letting up on the accelerator will also entail allowing some passive undoing of three rounds of large-scale asset purchases ("quantitative easing"). Should the Fed need to shift gears toward either more or less tightening, it will surely resort to the kind of communication we saw in the lead-up to the March meeting, when the triumvirate of Yellen, Vice Chairman Stanley Fischer and New York Fed President William Dudley sent loud signals a rate hike was imminent. For now, there is no rush to do anything. Much of recent economic data have been discouraging. Last month, non-farm payrolls grew a much less-than expected 98,000, while retail sales, manufacturing output and housing starts fell, as did consumer prices. First quarter GDP growth is tracking below 1% on an annualized basis. Then too, financial conditions have become less growth-supportive, at least in the stock market. The Dow has fallen 3% from its March 1 peak. Such disappointments matter, in as much as the FOMC has conditioned further "gradual" rate hikes on the economy growing sufficiently to make progress toward the Fed's goals of maximum employment and 2% inflation. Not surprisingly the fairly high odds that futures markets once placed on a June 14 rate hike have fallen considerably. But bear in mind residual seasonality and other factors have made first quarter GDP data notoriously unreliable in recent years. It's quite possible the economy will rebound by the time of the June meeting, or at least by September. Geopolitical uncertainties could also recede and markets recover. Then too, Fed officials pay more attention to labor market indicators than GDP, and despite the soft March payroll number, they remain content with progress there. Payroll gains averaged 178,000 per month in the first three months of the year -- well above the amount needed to reduce labor market slack. The household survey showed larger employment gains, and with the labor force participation rate staying at 63%, the unemployment rate fell to a near 10-year low 4.5%. Also cheering the Fed is faster wage growth. The Fed's "beige book" survey of conditions around the country through April 10 prepared for the May 2-3 FOMC meeting, found modest to moderate expansion in all 12 Fed districts and sounded upbeat about jobs and wages: "Labor markets remained tight, and employers in most Districts had more difficulty filling low-skilled positions, although labor demand was stronger for higher skilled workers. Modest wage increases broadened, and reports noted bigger increases for workers with skills that are in short supply." What's more, "a larger number of firms mentioned higher turnover rates and more difficulty retaining workers," the report said. Some blame soft first quarter growth on the Republicans' failure to implement health care and tax reforms, but realistically the effects of those and other policies -- and uncertainties about them -- are largely prospective. And while a handful of Fed officials have factored in potential Trump stimulus into their economic and rate projections, most have been very reluctant to make such assumptions. Fed officials are far from alarmed. In the past few days, Kansas City Fed President Esther George said the economy is "on a solid footing." Rosengren said, it "has continued to improve." Governor Jerome Powell observed, "we are at or close to full employment." Beyond the dot plot, the larger question is when the Fed will start shrinking the balance sheet. The answer is the Fed will likely curtail MBS reinvestments and Treasury rollovers much sooner than once expected. The FOMC reiterated in March it will continue reinvestments until rate hikes are "well underway." Yellen defined that phrase in terms of "confidence" in the economic outlook rather than in calendar terms. But FOMC minutes confirmed what I had been hearing -- that a majority felt "a change to the Committee's reinvestment policy would likely be appropriate later this year." Further balance sheet discussions will take place in May. Whenever the FOMC allows some maturing securities to run off, it is highly unlikely to abruptly halt reinvestments. It will proceed gradually, clearly and with as much advance notice as possible to avoid another 2013-style "taper tantrum." It may well differentiate between MBS and Treasuries and tailor reinvestments to monthly fluctuations in the amount of maturing securities and so forth. With massive amounts of Fed-held securities set to mature in coming years (e.g. $54.7 billion in Treasury notes and bond in May 2018), it will be a challenge for the Fed to manage the run-offs. Long-term rates are not much of a worry now, with the 10-year Treasury yield down to 2.24%, but going forward the Fed will have to move gingerly to avoid causing yield spikes. It could, for example, announce it will only allow so much per month to run off. Once it is on a two-track tightening course, the Fed will need to calibrate the total amount of tightening it seeks. By one trusted estimate, shrinking the balance sheet by $360 billion is equivalent to a 25 basis point rate hike. Short-term interest rate and quantitative policy are not walled off from each other. Whenever it begins shrinking the balance sheet, potentially pushing up long-term rates, the Fed's impulse to gradualism on short-term rates may well be reinforced. The Fed does not expect to return to the size balance sheet it had before the crisis -- around $900 billion. For one thing, policymakers expect there will continue to be higher demand for excess reserves. For another, the amount of currency outstanding (over $1.5 trillion) will limit shrinkage of the liability side of the balance sheet.