The Fed’s new framework has sown confusion

Central banks used to make a virtue of being boring and predictable. Jay Powell still might like to see himself that way, but some in the market seem convinced the Federal Reserve’s chair has a wild side.

Some investors think the combination of the $1.9tn stimulus that Congress has just passed and the tremendous pace of the US vaccine programme will lead to inflation so strong that it will force the Fed to raise rates as soon as next year. That’s despite the central bank signalling in December that the bulk of the policy-setting Federal Open Market Committee (FOMC) would not raise interest rates until 2024.

Most Fed watchers think the markets are wrong, arguing that hikes are likely to come in 2023 at the earliest — in spite of the improvements in the economic outlook.

They note that the Federal Reserve, haunted by a spate of premature rate hikes during the latter part of the noughties, has made it abundantly clear that it’ll allow the US economy to run hot to create full employment. Even if that means tolerating above-target inflation for a period of time. Powell has also said repeatedly that he does not think the stimulus will trigger the sort of persistent inflation that would require a central bank response.

Yet, we have some sympathy for why the markets are seemingly getting it wrong. Indeed we think it says a lot about the problems policymakers and their watchers are likely to face in the coming years.

Projections

The best tool the Fed has in explaining when rates will rise is its Summary of Economic Projections, specifically Figure 2, which lists all FOMC members’ assessment of where the benchmark federal funds rate will be over the course of the next few years, and in the longer term. Each dot represents a policymaker (including the five alternates that don’t have a vote right now). Here’s the chart from the December edition, which shows just five members thought rates would be higher than they are now by 2023:

The projections are published once a quarter, with the next round set to appear later on Wednesday following the FOMC vote. For anyone after a guide on what to look out for, we’d recommend this from Evercore ISI’s Krishna Guha and Alex Samuelson:

The central feature of the meeting will be the new Summary of Economic Projections, a chance for the Fed to provide the calendar type steer the market craves.

We think the new SEP will continue to show that a majority of FOMC participants still see no hike in either 2022 or 2023 (we see the first hike in mid-late 2023). If we are right on the SEP, Powell will have an opportunity to try to push back against two aspects of front-end market rate pricing: the difference between the market and the Fed on the inflation forecast, and, the difference between the market and the Fed on the Fed’s own reaction function.

The market will probably take its cue from the number of FOMC participants who defect from the majority and pencil in a hike in 2023. We think one or no defectors to 2023 hiking would be viewed in markets as dovish (Fed digging in), two defectors would be read as still dovish but closer to a wash and three — or more — defectors would be read as hawkish (majority for late hiking crumbling).

The Summary of Economic Projections would appear a straightforward guide on where rates are heading; all you’ve got to do is count the dots. So why are markets finding Powell so tricky to read right now?

Well a lot has changed (much of it for better) since the December projections were published. But it isn’t the first time that’s happened. So why this time is there such a disconnect between the views of seasoned Fed watchers and what markets think?

A more complex framework

As Panglossian as it was, monetary policymakers’ obsession with hitting their 2 per cent inflation targets had a certain mechanical charm to it. It made it easy to read what they would do next as there was only one input. The focus on inflation was myopic, so you only really had to look at what was set to happen to consumer prices. If these were heading above target, then expect tightening. And vice versa if inflationary pressures were too weak. Simple.

Under the Fed’s new framework it’s rather more complex for a few reasons. For starters, while the FOMC has made clear that they will tolerate a period of above target inflation, it is not clear for how long they would be willing to run the economy hot. Or by how much inflation could overshoot 2 per cent without them becoming seriously concerned.

The signal we’ve taken from officials’ remarks is the FOMC thinks the Phillips curve is so flat that they can run the economy hot for as long as it takes to get to full employment. But, even if you take that as given, you hit another problem: that determining what exactly constitutes full employment is far from straightforward.

As this Bloomberg article details, Powell is looking closely at measures such as black unemployment, wage growth for low earners and statistics for those without a college degree to see where the labour market’s at. If the past is anything to go by, placing a greater weight on these stats will mean that it will take longer for the US to reach Powell’s definition of “full employment” than it would have done to reach Janet Yellen’s, who focused more on US payrolls and average hourly earnings.

The Fed’s far from alone here in demanding central bank watchers look at a greater number of inputs now than in the past to understand how they think about the economy. New Zealand’s move to require the central bank to factor in house prices will have exactly the same effect. If we’re right and the era of central bank convergence is over, then others will soon follow suit.

We are not saying this is wrong — indeed we think it’s right that central banks no longer expect control of CPI inflation to be enough to produce economic and financial stability. More inputs make for a more honest worldview. But it’s messier too.

So while today’s Fed projections will do a lot to soothe the current market tensions and clarify rate expectations for the time being, we suspect there will come a point when, as inflation creeps higher, the Fed is forced to stare down the market and tell them they are serious about full employment.

That’s going to require not only predictability from Powell, but courage too. We think he’ll stick to his guns, but we can also appreciate why there are doubts.

Related links
Five things to watch out for from the Fed meeting — FT
The era of central bank convergence is over — FT Alphaville
The illusion of wage growth could haunt the Fed — FT Alphaville