Beckner: Confident Fed Moving Ahead Toward Two-Pronged Tightening

8 May, 2017

FOMC Unlikely To Shrink Balance Sheet, Hike Rates At Same Meeting Initially

Policymakers Not Thrown by Weak Q1; April Jobs Validate FOMC Judgment of Economy’s Fundamentals

by Steven K. Beckner

PALO ALTO, California - When the stronger-than-expected April employment report was released on Friday, there was a palpable sense of relief and vindication among Federal Reserve officials at a monetary conference hosted by Stanford University's Hoover Institution. After all, the March report had been disappointing, and gloomy retail sales and other data had suggested a faltering economy. The advance estimate of first quarter GDP growth was a meager 0.7%, and some early second quarter data didn't look very promising either. But Fed policymakers always suspected those numbers reflected yet another bout of the first quarter statistical doldrums that have plagued the U.S. economy for much of the last decade. So the 211,000 April jump in non-farm payrolls, coupled with a dip in the unemployment rate to 4.4% and 0.3% rise in average hourly earnings, was welcomed as validation of that view. More than one participant pointed with satisfaction to the second paragraph of the Federal Open Market Committee's statement of two days earlier. In leaving the federal funds rate unchanged, the Fed's policy body acknowledged the slump but called it "transitory" and predicted enough of a rebound to "warrant gradual increases" in that rate. If a hike at the June 13-14 FOMC meeting was ever off the table (and it wasn't), it's certainly back on now. Whether there is a third hike is a matter of dispute. But life isn't as simple as deciding how soon and how much to raise the funds rate. Much of the discussion at the conference was what to do about the balance sheet. The need to eventually pursue a two-track monetary tightening strategy -- raising the funds rate and shrinking the balance sheet by curtailing reinvestments of proceeds from maturing securities -- will complicate the FOMC's choices in coming months. The timing of rate hikes seems likely to be affected by the schedule for curtailing reinvestment. Thus far, Chair Janet Yellen and her colleagues have had the luxury of focusing almost single-mindedly on "normalizing" the funds rate. That was a choice made in 2014, when the FOMC determined it would be far easier to concentrate credit tightening on rates rather than on the quantity of reserves -- for management and communication reasons. The FOMC majority who wanted to delay balance sheet reduction after halting QE3 argued the Fed had more experience with changing the funds rate, and it had acquired the tools -- interest on excess reserves and overnight reverse repurchase agreements -- to push up the funds rate and other short-term rates despite bloated reserve balances and thereby influence financial conditions more generally. The Fed was also more confident in its ability to signal policy intentions through rate announcements and rate projections. Explaining monetary firming in terms of allowing less runoff of maturing securities presented more daunting challenges, such as "taper tantrum" risks. So the FOMC declared in a statement of Policy Normalization Principles and Plans that it would "cease or commence phasing out reinvestments" of its Treasury and mortgage backed securities only after it began by increasing the target range for the federal funds rate. When the FOMC first raised the funds rate in December 2015 after seven years near zero, it said it would continue reinvestments and rollovers until rate hikes were "well underway," as it did again last Wednesday. Meanwhile, preventing passive shrinkage of the balance sheet would "help maintain accommodative financial conditions," i.e. keep bond yields and thus long-term borrowing costs lower than otherwise. But eventually the FOMC knew "normalization" would have to encompass shrinking the balance sheet. Now that time is at hand. Arguably, short-term rate hikes are "well underway," so policymakers must confront the complicated task of following through on balance sheet reduction and putting upward pressure on long-term rates. Assuming the economy performs as hoped, the FOMC will start taking the first tentative steps toward trimming its bond holdings before much longer. Indeed St. Louis Federal Reserve Bank President James Bullard told the conference it is past time. Few are in that big a hurry, but minutes of the March meeting tell us most officials believed "a change to the Committee's reinvestment policy would likely be appropriate later this year." And there's no sign that consensus changed at last week's meeting. Boston Fed President Eric Rosengren told us tapering reinvestments needs to start "fairly soon." Chicago Fed President Charles Evans, appearing with Bullard and Rosengren, said "the Committee is looking forward to the upward sloping monetary path that I would say is pretty confidently in place. The fundamentals of the economy are good, and so we're moving up towards this place which we have described as a Committee: when it is well underway that the rate increases have been taking place, then we will start adjusting the size of our balance sheet by not reinvesting the maturing proceeds coming off...." Lessening reserve accommodation even as it hikes rates won't be easy. Reinvestment now works against rate hikes by exerting downward pressure on rates. Tapering reinvestments will equal some basis points of tightening which the Fed will have to calculate to determine the total amount of rate hikes and balance sheet shrinkage to do. In the early going, my sense is the Fed will separate the two. I'm told the FOMC will not want its first tapering of reinvestments -- or even advance notification -- to coincide with another incremental rate hike. That might be too much for the markets to digest and for the fed to communicate at one time, policymakers think. So it's likely the first steps to trim Fed securities holdings will be announced and at a meeting where rates are left unchanged. Once the Fed gets going on a predictable schedule of reduced reinvestments, the FOMC would presumably feel more comfortable resuming a gradual escalation of rate hikes. While a regular amount of allowed run-offs might seem ideal, it may not make sense given the varying amounts maturing from month to month. The Fed may find it needs to tailor reinvestments to those variations. It will also face a growing preponderance of MBS in its portfolio. As one person privy to balance sheet discussions confided, "it will take some fancy footwork." "There have been discussions about whether or not to let the full amount mature and not be reinvested," Evans revealed. "If you look at the monthly patterns, some months have larger maturities and that could get in the way of some of the Treasury funding. So sort of smoothing that out is one possibility..." If there are to be two more rate hikes this year, as envisioned in March, an ideal schedule might have the FOMC doing them in June and September (both meetings with scheduled press conferences and revised projections) -- then announcing initial reductions of reinvestments in December (another such meeting). The trouble is that economic and other developments may not permit such a plan. If the first quarter slowdown proves less transitory than expected and/or if international or financial developments unfold less favorably, as in recent years, the FOMC might have to stretch out normalization of both rates and balance sheet. The Fed could move at "off meetings" as Yellen has said is possible, provided she and her top lieutenants adequately prepare the markets. But the preference is still to move at meetings when a press conference and revised projections are scheduled. Of course, all further credit tightening is predicated on the economy living up to Fed expectations and making progress toward the statutory goals of maximum employment and price stability (defined as a symmetrical 2 percent inflation target). Lately, the data have been decidedly mixed. But the saving grace in officials' minds is that they've seen this movie before: first quarter horror giving way to happier endings. In wake of Friday's report, jobs are much less of a concern with payroll gains averaging well in excess of the minimum amount needed to absorb new entrants into the labor force, U-6 unemployment below most full employment estimates and wages rising faster. The nagging worry -- reinforced by similar trends abroad -- is that inflation is lagging behind. Just when it seemed inflation was headed toward 2%, the consumer price index and the more closely watched price index for personal consumption expenditures dropped. As suggested in the May 3 FOMC statement, officials remain fairly confident inflation will average 2% over the forecast horizon, and as we've seen that is all that's necessary for the Fed to tighten.