FED NOV FOMC PREVIEW: NO CAPITULATION TO PAUSE, LIKELY TOO SOON FOR MATERIAL TWEAKS

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1 Global Policy Global Policy & Central Banking Strategy Macro Note Krishna Guha Ernie Tedeschi November 05, 2018 FED NOV FOMC PREVIEW: NO CAPITULATION TO PAUSE, LIKELY TOO SOON FOR MATERIAL TWEAKS The November FOMC meeting that concludes this Thursday will be even more closely watched than usual following the past month of market turmoil. We think the Fed will continue to characterize the economy as strong and see virtually no chance that it will capitulate to demands that it should signal an early pause in its rate hiking cycle, in particular after Friday s strong jobs report. We also think there is little chance that the Fed will signal heightened concern for instance by stating that it is monitoring market developments or abandon its view that the risks to the outlook are roughly balanced. The more interesting question is whether the central bank might tweak its statement language in more nuanced but still material ways to address market concerns about Fed policy. In particular, the FOMC could adjust the statement consistent with Vice-Chair Clarida s recent comment that some further gradual rate increases are likely to be appropriate, a phrase that appeared to soften Chair Powell s unscripted long way from neutral remark that rattled markets. We do not feel that we can rule out that outcome given that Clarida s clarification of the message was almost certainly approved by Powell and note that the market would probably read the insertion of some into the statement change as quite dovish if it took place now rather than in December after another hike. It is also possible that the FOMC could use new language to refresh its commitment to data-dependence and/or find a light touch way to indicate that it will take persistent developments in financial conditions into account in assessing the ultimate extent of rate increases. But we think the Fed takes comfort from the relative stability of fixed income markets, will be wary of making any change that the market might read as very dovish, and will be more broadly uncomfortable about responding in a high frequency sense to equity market turmoil. For other reasons too the November FOMC meeting (which comes immediately after the midterm elections and lacks a scheduled press conference) is on balance probably too soon to insert some or make other material tweaks to the Fed s message, which are more likely to be put forward in speeches and testimony culminating in the December FOMC. So we do not have big expectations for changes to the statement at the November meeting. We would not read a largely unchanged statement as indicating that no refinement to the Fed message is en route simply that it will take a bit of time to emerge.

2 At the same time, we underline that with unemployment at 3.7 per cent and falling under late cycle fiscal stimulus, the Fed wants to engineer a soft landing and will view some tightening in overall financial conditions as consistent with this goal, even as it needs to be careful not to overdo it and owes markets a fuller explanation of how it will integrate developments in yields and market prices / risk premia (equity risk premium, credit risk premium, value of the dollar) in calibrating its hiking plans. Moreover, for the first time in a decade the Fed is now appropriately engaged in two-sided risk management guarding against both upside and downside risks, not one-sided downside risk management, and regardless of any fine-tuning of the Fed s message, markets have to adjust for this. Our detailed expectations for the statement and discussion of the underlying policy debates are as follows: ANALYSIS OF THE ECONOMY (FIRST PAR) We believe the Fed continues to read the US economy as strong following two very robust quarters of GDP growth. There is little evidence that Fed officials think the outlook has weakened in any material way in recent weeks, with household and business confidence at elevated levels, consumer fundamentals strong and ongoing fiscal stimulus through Meanwhile, the October employment report was about as good as it gets, with low unemployment, strong job gains, a pick-up in participation and wage gains that were firmer but still in line with the Fed s inflation objectives and should help sustain consumption going forward. We consequently expect that the statement will continue to affirm that the labor market has continued to strengthen, economic activity has been rising at a strong rate and household spending has grown strongly. The description of business fixed investment growth may be pared back in light of very recent data that suggest some loss of momentum potentially associated with US-China trade conflict but we think the FOMC will do so gently to avoid indicating any alarm, for instance by assessing that investment has expanded at a solid pace. There has to be some chance of an explicit nod to housing weakness, though this is not in our base case, in part because it was not cited in Vice- Chair Clarida s recent speech and in part because we do not think the Fed wants to present an overall bullish assessment of the current US data. US GDP - percentage point change by component SAAR Government Net Exports Inventories Residential Investment Nonresidential Investment Services Goods Net GDP Change Real Final Sales to Priv. Dom. Purchasers Change 6% 4% 2% 0% -2% -4% 2013-Q Q Q Q Q Q1 Source: BEA US ISM manufacturing & nonmanufacturing PMIs 50+=expansion Manufacturing Nonmanufacturing 46 Source: ISM 2

3 New one-family home sales & core retail sales growth New 1-Family Houses Sold (Thou.) (L) Core Retail Sales (Y/Y%) (R) 6.5% % % % % % % % 500 Source: US Census 95 US consumer & business confidence indicators NFIB - Small Business Optimism Index (L) Conference Board - Consumer Confidence (L) Business Roundtable CEO Economic Outlook - Diffusion Index (R) Source: Business Roundtable, NFIB, Conference Board Change in US total nonfarm payrolls - all employees Thousands M/M 3mo Moving Avg of M/M 0 Source: BLS US labor force participation rate 63.1% % 62.8% 62.7% 62.6% 62.5% Source: BLS Actual & flow-consistent U3 rate 3M moving average Actual Flowconsistent Source: BLS, Evercore ISI. ANALYSIS OF INFLATION / WAGES? (FIRST PAR) High frequency readings suggest near-term momentum in core inflation has softened a fraction, and underlying inflation for the year as a whole might come in very slightly less than the FOMC was expecting. Nonetheless, we think the Fed will continue to note that on a 12 month basis both headline and core inflation remain near 2 per cent and that Fed officials broadly assess that little has changed on the medium term inflation front. One interesting possibility is that the Fed might also observe that wages have firmed somewhat as both AHE and ECI now confirm this development. 3

4 Inflation break-evens have weakened in recent weeks but the Fed will judge that this is probably mostly explained by a temporary increase in the liquidity risk premium during market turmoil. We therefore expect no change to the assessment that indicators of longer-term inflation expectations are little changed on balance though there certainly might be a tweak that explains this assessment takes account of changes in risk premia. US headline & core PCE inflation - 6mo AR% & 12mo AR% Headline 6m AR% Headline 12m AR% 3.5% Core 6m AR% Core 12m AR% 2.5% 1.5% 1.0% 0.5% 0.0% Source: BEA, Evercore ISI US 5y5y inflation breakeven / 5y5y inflation swap 5y5y Breakeven 5y5y Swap 3.4% 2.6% 2.2% 1.8% 1.4% FRBNY Survey of Consumer Expectations 3yrs ahead & UMich 5-10yr ahead inflation rate expectations 3.85% 3.65% 3.45% 3.25% 3.05% 2.85% 2.65% 2.45% 2.25% FRBNY SCE - 3yrs Ahead Umich 5-10yr Umich 5-10yr (3mo MA) 2.05% Source: FRBNY, Reuters / U Michigan US compensation growth - AHE / Atlanta Fed wage growth tracker / ECI / ULC / comp per hour 5% 4% 3% 2% 1% Average Hourly Earnings All Employees, Total Private, Y/Y% Overall Wage Growth Tracker - 3mo Moving Avg % of Median Wage Growth Employment Cost Index, Total Compensation, Private Workers, Y/Y% Unit Labor Costs, Nonfarm Bus. Sector, Y/Y% Compensation per Hour, Nonfarm Bus. Sector, Y/Y% 0% Source: BLS, Atlanta Fed BALANCE OF RISKS, MARKETS AND INTERNATIONAL (SECOND / FOURTH PAR) We are very confident that the Fed will continue to characterize the balance of risks as roughly balanced in spite of market turmoil and international developments. We do not think the FOMC will make any reference to the idea that it is monitoring market developments as this would signal a degree of concern that the Fed does not currently have. We think Fed officials likely believe that global downside risks have increased some in recent weeks, primarily due to US-China trade conflict but also increased concern about Italy and fresh pressure on many emerging markets from the combination of trade, dollar, rates and oil. However we see no desire on the part of the FOMC to use the formal Fed statement to enter into running commentary on US trade policy and its implications or emulate the ECB in noting (somewhat helplessly) that international downside risks have gained in prominence. At most we might see a tweak that explicitly acknowledges international factors within a risk assessment that remains balanced, for instance taking into account domestic and international developments, risks to the economic outlook appear roughly balanced. 4

5 JP Morgan broad nominal effective TW USD US 10y government bond yield Source: JP Morgan 3.4% 3.2% 2.8% 2.6% 2.4% 2.2% Source: Bloomberg S&P 500 MSCI ACWI (global) equity index Source: Bloomberg 470 Source: Bloomberg BofA ML US HY bond index - option adjusted spread Source: BoA/ML Commodity price indices Index=100, Jan. 4, 2016 Bloomberg CMCI Industrial Metals Price Index Bloomberg CMCI Food Price Index Bloomberg CMCI Components Price Index, Brent Crude 75 SOME FURTHER OR JUST FURTHER GRADUAL INCREASES? (SECOND PAR) The most important question in our view for this meeting is whether the qualifier some used by Vice-Chair Clarida in his recent speech is added to the statement language that says the Committee expects that further gradual rate increases will be consistent with its economic goals. We read some as softening Powell s unscripted long way from neutral remark that unsettled financial markets and we believe came over harder than intended. Importantly, we are confident that Clarida acted with Powell s consent to refine the message. 5

6 In principle if some further gradual rate increases (from here) is now the leadership line, then it ought to find its way into the statement right away rather than in December (after another rate increase). The market would read this as dovish. However, the FOMC might be concerned that this would be read too dovish and the timing is awkward it might look as if the Fed was capitulating to market developments and it could be politically sensitive to shift right after the midterm elections. These considerations would tend to favor waiting to December to introduce some into the statement, likely as part of a larger overhaul that seeks to refine the Fed s message. An alternative way to read some in Clarida s speech is that it is not proto-statement language anyway, but rather guidance as to how to interpret the phrase in the statement, that may be picked up by Powell and Williams in speeches after the November meeting, but need not necessarily make it into the statement in either November or December. On balance we think some probably does not make it into the statement in November, but we are alive to this possibility. Evolution of fed funds futures implied rate curve from day before Sept. FOMC meeting to now 3.2% 2.8% 2.6% 2.4% 2.2% 1.8% Day Before Sept. FOMC Statement (Sept. 25) Day After Powell "Long Way Neutral" Comment (Oct. 4) Current (Nov. 2) 1.6% Jan Jan Jan Jan Fed fund futures implied rates and number of hikes End of Month Rates Hikes (from effective) Dec Mar Dec Dec POSSIBLE EDITS ON DATA DEPENDENCE / FINANCIAL CONDITIONS? (FOURTH PAR) We think that from now through year end a period spanning the November meeting, several Powell and other leadership speeches, testimony and the December FOMC meeting the Fed will seek to underline that policy remains data-dependent and that it will take persistent changes in yields and other financial conditions into account in assessing the appropriate extent of rate increases in order to avoid overkill. 6

7 The Fed could make tweaks to the statement in November that go in this direction. It could add the word data-dependent, for instance in the phrase this assessment will be data-dependent and will take into account a wide range of information It could also introduce a new reference to financial conditions, for instance by replacing the weak readings on financial and international developments with financial conditions and international developments. Data dependence though might be better handled in speeches and the chair s introductory remarks at press conferences, as was the case in the Yellen era. Some reference to financial conditions probably does belong in the statement, but to introduce it in November without a scheduled press conference in which to explain its meaning might introduce more noise than signal. On balance therefore we think that while this second tweak could well appear in November it will probably wait for the later phase of communications. ACM decomposition of the US 10y yield 4.0% Total Yield Term Premium Risk-free Average 3.5% 2.5% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% Source: FRBNY, Evercore ISI Bloomberg & Goldman Sachs financial conditions indices Bloomberg (L) Goldman Sachs (Inv) (R) Easier POSSIBLE HEADS-UP OR EVEN TWEAK TO IOER (THIRD PAR / DECISIONS REGARDING MONETARY POLICY IMPLEMENTATION) Finally, there is a possibility that the Fed could respond to upward pressure on the (traded) effective fed funds rate relative to the (administered) interest rate on excess reserves (IOER) by shaving IOER by 5 bp at the November meeting while keeping the target range for the federal funds rate unchanged. This would help keep the effective fed funds rate near the center of the target band. However, it would risk confusing markets as to the policy signal from the Fed at a very sensitive moment, and while Powell could call a press conference to clarify this it might all add up to unnecessary drama at a moment when the Fed wants to keep the tone calm and steady. If the Fed was expecting to shave the IOER rate at the November meeting we think this would be extensively trailed and explained (off the record) in media interviews to make sure the market did not confuse this technical adjustment with a shift in the stance of policy. As we have not seen this to date we do not expect the change in November, though we will keep an eye open for any late media on this topic. 7

8 We think the Fed is relatively relaxed about effective fed funds trading slightly above IOER and will likely assess that it can probably wait until December before adjusting the relative settings of its administered and target rates by raising IOER by 20 bp when it increases fed funds target by 25 bp. We cannot completely rule out the possibility that the FOMC might find some device to flag up the possibility of an intermeeting move on IOER if needed, for instance via an implementation directive that instructed the New York Fed to monitor conditions in the federal funds market with a view to a possible Board decision to adjust the relative setting of IOER and the federal funds rate target, and explained that this would not constitute a change in the monetary policy stance. But it seems easier to do this, if needed, later on via a speech from one of the leadership troika and / or media interviews. 8

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