By Steven K. Beckner
(MaceNews) – Going into its first meeting of the year, it might seem as if the Federal Open Market Committee has already scripted its monetary policy for coming months.
After all, Federal Reserve Chairman Jerome Powell and his colleagues on the Fed’s policy making committee have been pretty explicit about their intentions. Honoring the modern day commitment to central bank transparency, the FOMC has pre-announced the tapering down of asset purchases; has signaled increases in the federal funds rate from near zero will soon follow the conclusion of quantitative easing in mid-March, and has telegraphed that sometime after “liftoff” the start of “quantitative tightening” or balance sheet reduction will commence with much less delay than when it started QT more than four years ago.
FOMC participants have projected at least three 25 basis point hikes in the federal funds rate this year with more to follow.
There’s only one problem. Those plans and projections are predicated on certain economic forecasts, and as the Fed itself admits there is an extraordinary amount of uncertainty about the outlook. Fed forecasts have infamously gone awry many times over the years.
And so, as in so much in life, things monetary don’t always go according to plan. Fed projections aren’t always fulfilled. Indeed, more often than not they don’t. Hence, the Fed has always given itself plenty of leeway to adjust policy in midstream.
As minutes of the Dec. 14-15 FOMC meeting disclose, “Participants continued to stress that maintaining flexibility to implement appropriate policy adjustments on the basis of risk-management considerations should be a guiding principle in conducting policy in the current highly uncertain environment.”
We need only think back to the last time the FOMC shifted from easing to tightening to recall how off-base Fed plans can turn out to be. After the FOMC belatedly ended its third round of quantitative easing in October 2014, the FOMC made a significant rhetorical change at its December 2014 meeting. It stopped saying it would keep the federal funds rate in a zero to 25 basis point target range “for a considerable time” and instead said it “can be patient in beginning to normalize the stance of monetary policy.” FOMC participants projected four 25 basis rate hikes in 2015.
But, with international financial events impinging on the outlook, the FOMC left the funds rate near zero throughout that year, finally raising it only once by 25 basis points on Dec. 16, 2015 to a 25-50 basis point target range.
Much the same happened the following year. In December 2015, FOMC participants again projected four rate hikes for 2016, but once more it ended up doing only one hike on Dec. 14, 2016 to 50-75 basis points.
Nor did the Fed follow its original timetable for shrinking the balance sheet after belatedly starting to do so three years after finishing QE3.
So, while it’s possible the FOMC’s median forecast of 4% real GDP growth and 3.5% unemployment with 2.6% inflation will hold true, we may well get a very different result, which would alter officials’ assessments of the “appropriate” monetary stance.
And that doesn’t even allow for other eventualities – some new untoward Covid development, one of a number of potential geopolitical eruptions, not to mention financial market perturbations that could crop up.
Then too, a new cast of characters at the Board of Governors (and the FOMC) will arrive at some point. President Biden has nominated three new governors, and sitting governor Lael Brainard looks set for confirmation to succeed Richard Clarida as vice chairman. It’s too soon to say, but the consensus could shift toward less monetary tightening than now envisioned, whatever the circumstances.
The FOMC seems very unlikely to take fresh action next Wednesday so soon after a dynamic December meeting, but the Jan. 25-26 meeting is apt to feature an important strategy session – continuing to consider how best to proceed with monetary “normalization” in coming months and even beyond.
Fed governors and presidents won’t be going through their quarterly exercise of making economic forecasts and funds rate projections again until the March 15-16 meeting, but they will be taking fresh stock of the economy, in particular inflation and employment. And they will have to evaluate how the ever-evolving virus might affect the outlook.
The inflation picture is not pretty, to say the least. Last month, the consumer price index rose at a year-over-year rate of 7% – worst in nearly 40 years. Wages have also been soaring. Average hourly earnings rose at a 4.7% year-over-year rate in December, raising the dread specter of a wage-price spiral.
The Fed’s beige book survey, prepared for review at the upcoming meeting, found that “tightness in labor markets drove robust wage growth nationwide, with some Districts highlighting additional growth in labor costs associated with non-wage benefits. While many contacts noted that wage gains among low-skill workers were particularly strong, compensation growth remained well above historical averages across industries, across worker demographics, and across geographies.”
Although Powell and his colleagues finally stopped calling high inflation “transitory” in late November, they are still holding out hope that inflation will moderate substantially this year. The FOMC’s Dec. 15 Summary of Economic Projections had the price index for personal consumption expenditures, the Fed’s preferred inflation gauge, coming down to 2.6% by the end of 2022, then falling further to 2.3% next year.
Fed officials’ operating premise is that supply chain constraints and labor shortages will resolve as the year wears on and that consumer demand will shift away from durable goods toward services in a more traditional spending mix. They are also somewhat comforted that, although short- and medium-term measures of inflation expectations have jumped, longer term inflation expectations seem to have remained “well-anchored.”
But again no one knows how bad inflation will be this year and to what extent it has become embedded in household and business expectations and behavior. They can only hope inflation will come down as supply-demand imbalances ease.
Officials have not readily admitted that massive money creation, coupled with the Fed’s monetization of record federal deficit spending, is helping fuel demand pressures on wages and prices, but the policy shift of recent months has to be seen as a tacit admission that the Fed is part of the problem.
Fed policymakers have belatedly come to the realization in the last few months that they cannot leave hard-won price stability to chance. The FOMC has come far and fast in its last few meetings – moving from a posture of keeping monetary policy extraordinarily accommodative for an indefinite period to moving swiftly to withdraw a significant amount of that accommodation, prospectively anyway.
Labor market improvements have moved the FOMC closer to its “maximum employment” objective, enabling it to pay more attention to the “price stability” side of its dual mandate. Last month, although non-farm payrolls rose a disappointing 199,000, household survey data were stronger, letting the unemployment rate fall to 3.9%.
Although the labor force participation rate remains less than satisfactory at 61.9%, and although there are other signs that the United States has not really returned to full employment, there has been a noticeable rhetorical shift in Fed officials’ rhetoric on labor market conditions.
At his Dec. 15 post-FOMC press conference, Powell said “We’re making rapid progress toward maximum employment.” And he continued to express that sentiment in testimony before a Jan. 11 confirmation hearing on his renomination to a second four-year term as Fed chairman. “Today the economy is expanding at its fastest pace in many years, and the labor market is strong,” he told the Senate Banking Committee.
And so, Powell said, “It really is time for us to begin to move away from those emergency pandemic settings to a more normal level. It really should not have negative effects on the employment market.”
Similar sentiments came from other officials.
“With inflation running at close to a 40-year high, considerable momentum in demand growth, and abundant signs and reports of labor market tightness, the current very
accommodative stance of monetary policy is out of sync with the economic outlook,” Kansas City Federal Reserve Bank President Esther George, a 2022 FOMC voter, said in a Jan. 11 speech.
New York Fed President John Williams, the FOMC vice chairman, spoke a few days later of “dramatic improvement in the labor market.”
Even Brainard, who is not known for hawkishness, seemed to be on board with early monetary tightening in a hearing on her nomination to become vice chairman.
“We’re very concerned about the high level of inflation,” she told the Senate Banking Committee. “We are committed at the Federal Reserve to bringing it back down to target. We’re taking a number of actions.”
“We’ve already decided to end asset purchases in the first quarter. …,” she continued. “(The) Committee has projected several hikes over the course of the year… We will be in a position to do that as soon as asset purchases are terminated.. We will simply have to see what the data requires over the course of the year.”
Although the upcoming meeting is not likely to yield immediate action, it marks another milestone on the FOMC’s journey from crisis mode to normalization.
If, as Powell said in December, asset purchases end in mid-March, the next step will be to raise the funds rate if the FOMC follows historical precedent, as seems very probable. (The FOMC does not want to be raising rates while still expanding the balance sheet).
It increasingly looks like the first hike will come soon after the end of tapering. At the December FOMC meeting, the minutes tell us participants generally thought “it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated.”
Increasingly, it appears the first rate hike will come March 16, judging from the kind of signals officials have been sending.
Powell, in his confirmation hearing, declared, “it is really time for us to begin to move away from those emergency pandemic settings to a more normal level. It’s a long road to normal from where we are.”
Williams, Powell’s top lieutenant, who is not known for loose talk, also seemed to point toward early liftoff:
“We have had such dramatic improvement in the labor market, and inflation is higher than we want,” he said. So “it does make sense (to start raising rates). We’re approaching that kind of decision.”
Williams said “the economy is in a great place in terms of employment and GDP.” So “it makes sense for monetary policy to evolve as the economy evolves.”
“We’re in a good position to do that in a way that’s not disruptive,” he added.
Asked how many times the FOMC is apt to raise the funds rate this year, Williams said “there’s a lot of uncertainty,” but the “baseline view” is that “it’s really about a path back to more normal interest rates … to somewhere above 2% down the road.”
“So it’s really not so much (doing) so many rate increases this year or next year,” he continued. “It’s really about the movement to that over the next year or two – any kind of path that would get you toward that is the goal.”
“And like I said, we’re approaching that kind of decision to get that going,” he reiterated. “It’s appropriate to start moving policy in that way, removing accommodation gradually and communicating that’s what we’re expecting.”
Beyond liftoff, the next step is reducing the $8.8 trillion bond portfolio the Fed built up after the onset of the pandemic in March 2020 led it to not only cut the funds rate to zero but to buy some $4 trillion of Treasury and agency mortgage backed securities.
The FOMC could also get going on that relatively soon – not in March, but perhaps as soon as mid-year. Powell told the Senate Banking Committee he expects that to happen “sooner and faster” than in the 2014-17 period – both because the economy is stronger than it was then and because the balance sheet is much bigger.
George, meanwhile, suggested the Fed has no choice but to shrink the balance sheet early in the monetary firming process: “All else equal, maintaining a large balance sheet could imply a higher short-term interest rate to offset the stimulative effect of the balance sheet’s continued downward pressure on longer-term interest rates. An approach of raising rates while maintaining an out-sized balance sheet could flatten the yield curve and distort incentives for private sector intermediation, especially for community banks, or risk greater economic and financial fragility by prompting reach-for-yield behavior from long-duration investors.”
“For that reason, my own preference would be to opt for running down the balance sheet earlier rather than later as we plot a path for removing monetary accommodation,” she said.
George recalled that in the last normalization cycle, “the FOMC delayed adjusting the size of the balance sheet until the normalization of the funds rate was ‘well under way’” because of “the novelty of balance sheet normalization and the desire for space to offset any unexpected turbulence.”
But she said “this rationale seems less compelling now and, from my perspective, discounts the yield curve implications of moving the funds rate higher while maintaining a large balance sheet.”
“All in all, I believe that it will be appropriate to move earlier on the balance sheet relative to the last tightening cycle,” George added.
Atlanta Fed President Raphael Bostic, who has called for raising the funds rate in March to counter “a risk that inflation is likely to be elevated for an extended period of time,” recently proposed slashing Fed bond holdings by $100 billion per month. Governor Christopher Waller has made similar calls.
Asked about such proposals, George replied that her “real focus is on beginning the important communication that has to accompany the Federal Reserve beginning to withdraw accommodation. Right now, the signal has come, which is, we will begin to back off of accommodation, but of course we are still adding each month to the balance sheet.
George said the FOMC should begin by raising the funds rate, but said, “I don’t think we can ignore the fact that we have an extraordinarily large balance sheet this time, and so I think we’re going to have to think about both of those3 instruments – both the interest rates as well as the balance sheet….I think it’s time for us to really talk about that in earnest..”
History is instructive.
Before the FOMC actually began shrinking the balance sheet in October 2017 (three years after QE3 ended), it first adopted a set of balance sheet normalization “principles and plans” four months earlier, in which it outlined how it intended to progressively decrease security holdings.
In that June 2017 “Addendum to the Policy Normalization Principles and Plans,” the FOMC stated, “The Committee intends to gradually reduce the Federal Reserve’s securities holdings by decreasing its reinvestment of the principal payments it receives from securities held in the System Open Market Account. Specifically, such payments will be reinvested only to the extent that they exceed gradually rising caps.”
• “For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month.
• “For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-month intervals over 12 months until it reaches $20 billion per month.
• “The Committee also anticipates that the caps will remain in place once they reach their respective maximums so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.”
After the markets had had a chance to digest that plan, the FOMC announced on Sept. 20, 2017, that the June plan would be initiated in October.
This year, the FOMC seems likely to take a broadly similar approach when the time comes.
The FOMC began discussing management of the Fed’s bloated balance sheet in December after listening to staff presentations, and Powell has let it be known those deliberations will continue at the upcoming meeting. It seems unlikely a final plan for shrinking the balance sheet – both in absolute magnitude and as a proportion of GDP – will be released next week, but the FOMC will presumably be working toward a major announcement in the not too distant future.
In a December Discussion of Policy Normalization Considerations, FOMC participants talked about “the lessons learned from the Committee’s previous experience with policy normalization, alternative approaches for removing policy accommodation, the timing and sequencing of policy normalization actions, and the appropriate size and composition of the Federal Reserve’s balance sheet in the longer run.”
Among the areas of agreement were that advance communication of normalization principles and plans “enhanced the public’s understanding and thus the effectiveness of monetary policy”; that “the previous experience highlighted the benefits of maintaining the flexibility to adjust the details of the approach to normalization in response to economic and financial developments,” and that “changes in the target range for the federal funds rate should be the Committee’s primary means for adjusting the stance of monetary policy…”
FOMC participants also concurred that “key differences between current economic conditions and those that prevailed during the previous episode” would have to be taken into account.
“Most notably, participants remarked that the current economic outlook was much stronger, with higher inflation and a tighter labor market than at the beginning of the previous normalization episode,” the minutes say. “They also observed that the Federal Reserve’s balance sheet was much larger, both in dollar terms and relative to nominal gross domestic product (GDP), than it was at the end of the third large scale asset purchase program in late 2014.”
What’s more, the current weighted average maturity of the Fed’s Treasury holdings “was shorter than at the beginning of the previous normalization episode.”
Therefore, some officials observed that “depending on the size of any caps put on the pace of runoff, the balance sheet could potentially shrink faster than last time if the Committee followed its previous approach in phasing out the reinvestment of maturing Treasury securities and principal payments on agency MBS.”
There was not unanimity, though. “Several participants raised concerns about vulnerabilities in the Treasury market and how those vulnerabilities could affect the appropriate pace of balance sheet normalization.” A couple thought the Fed’s Standing Repo Facility (SRF) “could help to mitigate such concerns.”
Notwithstanding such concerns, the minutes say participants “judged the Federal Reserve to be better positioned for normalization than in the past, as the ample-reserves framework and the Federal Reserve’s current interest rate control tools, including interest on reserve balances and the overnight reverse repurchase agreement (ON RRP) facility, are in place and working well.”
And “some participants judged that a significant amount of balance sheet shrinkage could be appropriate over the normalization process, especially in light of abundant liquidity in money markets and elevated usage of the ON RRP facility.”
The minutes say “almost all” FOMC participants agreed last month that “it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the target range for the federal funds rate.”
But they “judged that the appropriate timing of balance sheet runoff would likely be closer to that of policy rate liftoff than in the Committee’s previous experience” because of “a stronger economic outlook, higher inflation, and a larger balance sheet and thus could warrant a potentially faster pace of policy rate normalization.”
Anticipating George’s concerns, the minutes say some participants worried “removing policy accommodation by relying more on balance sheet reduction and less on increases in the policy rate could help limit yield curve flattening during policy normalization” and that “a relatively flat yield curve could adversely affect interest margins for some financial intermediaries, which may raise financial stability risks.”
And reflecting Powell’s “sooner and faster” approach, the minutes say “many participants judged that the appropriate pace of balance sheet runoff would likely be faster than it was during the previous normalization episode.”
The FOMC seemed to like the graduated caps approach used in 2017. Many participants “judged that monthly caps on the runoff of securities could help ensure that the pace of runoff would be measured and predictable, particularly given the shorter weighted average maturity of the Federal Reserve’s Treasury security holdings.”
Beyond the pace of shrinkage, the FOMC “discussed considerations regarding the longer-run size of the balance sheet consistent with the efficient and effective implementation of monetary policy in an ample-reserves regime.”
Yet to be decided is how big the balance sheet should be after “normalization.” In December, participants thought “the current size of the balance sheet is elevated and would likely remain so for some time after the process of normalizing the balance sheet was under way.”
“Several participants noted that the level of reserves that would ultimately be needed to implement monetary policy effectively is uncertain, because the underlying demand for reserves by banks is time varying,” the minutes elaborate. “In light of this uncertainty and the Committee’s previous experience, a couple of participants expressed a preference to allow for a substantial buffer level of reserves to support interest rate control.”
“Participants noted that it would be important to carefully monitor developments in money markets as the level of reserves fell to help inform the Committee’s eventual assessment of the appropriate level for the balance sheet in the longer run.”
The FOMC will also be doing its annual review of its “Statement on Longer-Run Goals and Monetary Policy Strategy.”
That is usually a perfunctory exercise, but the FOMC has been operating under the current longer run policy strategy or “framework” for only 16 months, and not everyone would contend it’s been a rousing success.
The Committee announced a new policy framework in August 2020, which it began implementing in September of that year, then reaffirmed it last January. It was a major departure. For starfters, the FOMC moved “flexible average inflation targeting” and undertook to let inflation overshoot its averge 2% inflation target for some time to compensate for past undershooting. Moreover, it announced that, henceforth, it redefined its “maximum employment” objective as “a broad-based and inclusive goal” which would be measured by “assessments of the shortfall of employment from its maximum level,” as opposed to the previous “deviations from its maximum level.”
As interpreted by Powell and his colleagues, the new framework meant that the Fed would no longer tighten monetary policy in anticipation of tight labor markets generating above target inflation.
The FOMC is not expected to significantly revise the statement this January, but it might do well to consider the framework’s policy implications in this new world of unexpectedly stubborn and worrisome inflationary pressures.
Some would say the FOMC outsmarted itself and put itself in a box of its own device.
Worried that perennial sub-target inflation could continually leave the Fed perilously close to the zero lower bound and limit its monetary flexibility, the FOMC deliberately adopted a strategy of letting the economy “run hot” to achieve a reimagined version of maximum employment, while actively encouraging inflation to run higher than target “for some time.”
Well into 2021, some Fed officials were expressing concern that inflation and inflation expectations weren’t high enough and were rooting for more inflation. Now they may rue the day.
With inflation overshooting far more than the FOMC ever anticipated, or wanted, the Fed finds itself saddled with a framework that makes it harder for them to tighten credit, that inclines monetary policy toward excessive ease, or at least delays action to counter inflationary pressures..
Belatedly, the Fed has become alarmed about inflation (ceasing calling it ‘transitory” only late last year) and has begun talking about being close to full employment. But some, including former New York Fed President Bill Dudley, are accusing the Fed of being “behind the curve.”
The Fed’s primary responsibility is protecting the purchasing power of the dollar, but under its new framework its credibility has been called into question.
Contact this reporter: steve@macenews.com
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