As widely expected by Zero Hedge, barely a few months after the arrival of former Goldmanite Mario Draghi to head ECB, the ECB's balance sheet exploded by nearly $1 trillion. Naturally, such is the way of central banks infiltrated by tentacles of the squid: no surprises. Which brings us to the first Fed meeting of 2012 and its public manifestation: the FOMC's January 25 statement. As is well known, while the Goldman addition to the ECB is a recent development, its agent at the Fed, the head of the FRBNY Bill Dudley has been there for a quite a while - in fact ever since the tax-challenged Mike Judge character impersonator left to become Treasury Secretary. As was suggested on Zero Hedge, it was the meetings of Bill Dudley with Goldman's Jan Hatzius at the Pound and Pence, and of course elsewhere but these are the only public recorded ones, that have shaped monetary policy more than anything. In other words, if anyone can predict, not to say define, US monetary policy, it would be Jan Hatzius. Below are his just released "thoughts" on what to expect on Wednesday. What is odd is that whereas a month ago Goldman was convinced that an LSAP version of QE was imminent, now the firm has become substantially less optimistic. Is it time to manage down expectations? To wit: "Given the improvement in the economic indicators and the easing of financial conditions that has occurred in the meantime, we believe it is less central now. While Fed officials are certainly not targeting a tightening of conditions, we doubt that they will "bend over backwards" to deliver a dovish surprise relative to current market expectations." So just how much QE3 is priced in if Goldman is already doing disappointment damage control. Or did Goldman finally wise up and realize that the only effective Fed statement is the one that surprises. So if Goldman does not publicly expect QE3, and we do in fact get a notice thereof, it will have an immediate knee jerk reaction on risk, and of course, Gold. These and many more questions shall be answered at 12:30 pm on Wednesday.
FOMC Preview
- We expect the inaugural set of FOMC forecasts for the federal funds rate--or more precisely, the projections of the appropriate level by the 17 meeting participants in the Summary of Economic Projections (SEP)--to be clustered around a median of 0.75% by the end of 2014.
- We believe the committee will eliminate the "mid-2013" rate commitment from the FOMC statement because it is now redundant and potentially confusing. However, this is a fairly close call. It is also possible that the committee will keep this phrase for one last time, in order to avoid sending what would likely be perceived as a hawkish signal before the new framework has been fully explained to the public.
- It appears that a discussion of the outlook for the Fed balance sheet will not be available until the full SEP is published alongside the FOMC minutes on February 15, although Chairman Bernanke may reveal some of the committee's thinking in the press conference.
- The committee might also release a statement on its longer-term goals and strategy, which would probably involve adoption of a flexible inflation target coupled with a reinforced commitment to the employment part of the dual mandate. However, it is unclear whether this statement is ready to be published yet.
Q: What will happen on Wednesday?
A: Following its two-day meeting on January 24-25, the Federal Open Market Committee (FOMC) will publish the following:
12:30 pm: The regular FOMC policy statement.
2.00 pm: Materials from the Summary of Economic Projections (SEP). These will include:
1. An expanded version of Table 1 showing the range and central tendency--the range excluding the top 3 and bottom 3 entries--of the 17 FOMC meeting participants' projections for real GDP growth, the unemployment rate, the headline and core PCE price index, and presumably the federal funds rate, by year through the end of 2014 as well as for the "longer term." (There will be no "longer-term" projection for the core PCE index.)
2. The entire distribution of 17 projections (without attribution) for the federal funds rate by year through the end of 2014, as well as the "longer term."
3. The entire distribution of 17 projections (without attribution) for the year of the first rate hike through 2016. Somewhat to our surprise, the template for the projections released on Friday afternoon suggests that the date of the first hike will only be specified in annual terms; we had expected quarterly or at least semiannual information.
2.15 pm: Opening statement for the chairman's press conference.
Q: Will we get a qualitative discussion of the outlook for the Fed balance sheet?
A: Probably not until the full SEP is published on February 15, alongside the FOMC minutes. However, Chairman Bernanke might reveal some of the committee's thinking in the press conference, which is virtually certain to feature questions about the outlook for the balance sheet.
Q: Anything else?
A: The FOMC might also release a statement about its longer-term monetary policy goals and strategy. This would probably involve an explicit--but flexible--inflation target formulated as a headline PCE inflation rate of 2% over the medium term, but with room for significant deviations in the shorter term. We do not view this as a big change relative to the current language about the "mandate-consistent" inflation rate. In order to counteract the impression that this is a "hawkish" shift, we believe the committee would also find a way to strengthen the employment side of the dual mandate, perhaps by talking about a target of zero for the gap between the unemployment rate and its structural level (i.e. the "longer-term" projection in the SEP).
It is clear that some type of statement is in the works. However, we do not know whether it will already be released on Wednesday or at a subsequent meeting. The minutes of the December FOMC meeting were noncommittal on timing, and remarks by some Fed officials in the meantime had pointed to a later date. But an article by Jon Hilsenrath in the Wall Street Journal on Friday suggested that the statement might be ready to go after all.
Q: What will the forecasts show?
A: Our estimates are in Exhibit 1 below:
Exhibit 1: Our Estimates for the Fed's Summary of Economic Projections
The key point is that while we expect the fed funds rate projections to range quite widely, we think that the median participant will project a funds rate of just 0.75% by the end of 2014 (see Sven Jari Stehn, "Forecasting the FOMC's Forecasts," US Economics Analyst, 12/01, January 7, 2012). This would imply that the median participant expects the first rate hike in 2014.
Also, we expect a long-run estimate for the federal funds rate--which may be interpreted as the committee's view of the "neutral" rate--clustered around a median of 4%.
Q: What will the statement show? In particular, will the phrase that "economic conditions…are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013" be retained, expanded, or eliminated?
A: We don't expect significant changes in either the growth or inflation paragraphs of the statement. Although the data have been generally stronger than expected, the basic message of "moderate expansion" still looks appropriate.
However, we expect the committee to eliminate the "mid-2013" phrase. The whole point of the SEP funds rate projections is that they are a better avenue for providing guidance on future policy than the statement, not that the Fed needs an additional avenue for such guidance (see "Why the FOMC Should Forecast Its Own Policy," US Daily, October 24, 2011):
1. They are more informative than the mid-2013 language because they provide an entire path for the funds rate, not just the timing of the first hike.
2. They are more clearly conditional because the funds rate forecasts are published in the same document as the economic forecasts, which makes it very clear that changes in the latter would cause changes in the former.
3. They provide a more natural avenue for acknowledging both uncertainty and disagreement within the committee, without forcing it to settle on the lowest common denominator. This is a key reason why we think that the projections will show the first hike in 2014, while the FOMC statement was only able to promise no hikes before mid-2013. (Of course, Fed officials have said that even the mid-2013 language is not a full commitment; our view is that it is somewhere in between a commitment and a mere forecast.)
In our view, it would be quite problematic to have the SEP projections and the FOMC rate guidance co-exist, as many market participants seem to be expecting. If they are consistent with one another, nothing is gained by retaining both types of guidance. And if they are inconsistent, this could cause great confusion.
Q: But wouldn't an elimination of the mid-2013 language from the statement be viewed as a hawkish signal?
A: We don't think it should be. All else equal, it is true that a date in the statement is more of a commitment than a forecast path in the SEP, as noted above. But all else is not equal; the SEP is very likely to point to a significantly longer period of near-zero rates than the mid-2013 guidance in the statement. And we do not believe that replacing a slightly stronger (but still conditional) commitment not to raise the funds rate until mid-2013 with a slightly weaker commitment not to raise the funds rate until 2014 would be a net tightening; if anything, we would view it as an easing.
That said, there is a timing issue because the FOMC statement is released at 12.30 but the SEP materials do not come out until 2. This could conceivably trigger an adverse market reaction in the short term. We doubt that this looms very large in the minds of Fed officials, but if it is a concern it is possible that the committee will decide to keep the mid-2013 guidance in the statement one last time, and then have the chairman explain in the press conference why it will disappear in the future.
Q: Would an elimination of rate guidance from the statement reduce the chairman's influence?
A: To a degree, yes, because all FOMC meeting participants including the 7 nonvoting presidents--whose views are on average more hawkish and less aligned with the chairman's--will contribute to the forecasts. We flagged this issue in our October 24 piece and suggested one way to address it, namely to distinguish between the projections of voting and nonvoting participants. Judging from the templates for Wednesday's release, however, Fed officials seem to have decided against such a distinction, probably because it would be too divisive.
But we should not forget that the introduction of press conferences has increased the chairman's ability to shape the overall message. If the chairman uses the press conference to shed light on the outlook for the Fed's balance sheet (in advance of the full SEP to be released three weeks later) this will imply a further increase in his ability to shape the message. This puts the partial loss of control over the rate guidance into perspective.
Q: How do your expectations stack up against the market's view?
A: Our estimate of the median funds rate forecast of 0.75 percent at the end of 2014 is in line with current market pricing. However, it is important to remember that the permanent voters generally hold more dovish views than the rotating voters, and that the Fed's funds rate forecasts are likely to be based on somewhat above-consensus views of the economic outlook. Both of these points suggest that the message about the reaction function might look slightly dovish relative to current market pricing.
Against this, however, there are other aspects that might look more hawkish:
1. The "mid-2013" language. The Goldman Sachs US Rates Trading desk conducted a survey of its clients last week in which 82% of respondents indicated that they expect the committee to either retain or expand the "at least mid-2013" commitment in the FOMC statement. In contrast, our expectation ias that they will replace it with the funds rate forecasts. If we are right, some disappointment is certainly possible.
2. The neutral funds rate. We believe the FOMC will show a median estimate of the longer-run funds rate of 4%. In contrast, 72% of survey respondents thought it would be below 4%, and 39% thought it would be below 3.5%. We would be very surprised by such a low number.
3. QE guidance. The Fed seems set to provide less guidance on the outlook for the balance sheet than many market participants are expecting. This may be viewed as a disappointment.
4. The motivation for moving to the new framework. Many market participants seem to believe that the primary motivation is to ease financial conditions. In contrast, our view is that the primary motivation is that Fed officials view monetary policy forecasts as a structural improvement in their communication with the markets and the public. The desire to ease financial conditions probably played a more important role when the move toward the new regime first got underway 3-6 months ago. However, given the improvement in the economic indicators and the easing of financial conditions that has occurred in the meantime, we believe it is less central now. While Fed officials are certainly not targeting a tightening of conditions, we doubt that they will "bend over backwards" to deliver a dovish surprise relative to current market expectations.