Goldman's Sven Jari Stehn answers the 11 most critical questions regarding to day's "most-important-FOMC-meeting-ever."
Q: Will "considerable time" be dropped?
A: Yes, we believe the "considerable time" language will be dropped. December has for some time looked like the most natural meeting for modifying the guidance given the leadership’s expectations for liftoff in mid-2015, the typical translation of “considerable time” into about six months, and the absence of a press conference in January. Speeches by Fed Vice Chairman Fischer and New York Fed President Dudley two weeks ago confirmed that we are getting closer to the date when "considerable time" will be removed. Since then we have seen a strong employment report and a bounce-back in University of Michigan long-tem inflation expectations, which reinforce the expectation that the guidance will be modified.
We do not, however, think that a change in guidance is a done deal. First, while a number of Fed officials have explicitly or implicitly voiced support for switching the forward guidance towards “patience,” others including San Francisco Fed President Williams are comfortable with “considerable time.” Second, the October minutes suggest that some participants were worried that the removal of considerable time might be seen as a shift in the stance of monetary policy and therefore tighten financial conditions. The continued decline in oil prices and market-implied inflation expectations, as well as the recent turmoil abroad, might well reinforce these existing concerns.
Q: How will "considerable time" be modified?
A: Recent Fed communication has focused on two themes: the word “patient” has shown up frequently and Fed officials have continued to stress that policy is data dependent. One possibility to combine these themes would be to follow Boston Fed President Rosengren’s formulation and state that the "committee expects to be patient in beginning the normalization of the target range for the federal funds rate until it is clear that the economy is on the path to achieving both the 2 percent inflation target and maximum sustainable employment.”
The leading alternatives, in our view, would be either to keep "considerable time" or adopt "patient" without the data dependence. The former would increase the likelihood of the first hike occurring in September of next year. The latter would raise the parallel with 2004--when "considerable period" gave way to "patient" in January and the FOMC hiked in June--and thereby increase the chance of a rate hike in June or even earlier.
Q: The October FOMC minutes showed concern amongst participants that removing "considerable time" might tighten financial conditions. How could the FOMC limit this risk?
A: The committee could state explicitly that the change in guidance is not intended to signal a change in its policy intentions. One possibility would be to do so in the FOMC statement. For example, the committee could follow the December 2012 formulation--when the committee dropped its calendar-based guidance and adopted the unemployment and inflation thresholds--and state after the updated guidance sentence that "the committee views the updated formulation as consistent with its earlier guidance." Or Fed officials could adopt the March 2014 template and say at the end of the FOMC statement that "the Committee has updated its forward guidance. The change in the Committee's guidance does not indicate any change in the Committee's policy intentions as set forth in its recent statements." Another possibility would be for Chair Yellen to make one of these statements in the press conference. Given the 30 minute time lag between the statement (in which considerable time would be modified) and the press conference, we think it is most likely that this formulation would be included in the FOMC statement, in order to avoid any ambiguity.
Q. Market-implied inflation expectations have continued to decline in recent days. How will the FOMC respond?
A: We would expect the committee to acknowledge the ongoing drop in breakevens in the statement by, for example, noting that market-based measures of inflation compensation have “continued to decline” (instead of “declined somewhat”). But we would not expect the committee to go much beyond that for a couple of reasons. First, it is likely that at least part of the decline in market implied inflation expectations—even at long forward horizons—is connected to the drop in crude oil prices. Second, New York Fed President Dudley argued that the inflation risk premium might have come down. Third, survey measures of inflation expectations have generally remained stable, on net. The University of Michigan 5-10 year inflation expectations measure bounced back in the preliminary December report and the New York Fed measure of inflation expectations has remained stable throughout.
Q. Financial conditions have continued to tighten and crude oil prices have continued to plummet. What are the likely implications for the committee's economic outlook?
A: The effects of tighter financial conditions and lower oil prices should be directionally offsetting for growth and reinforcing for inflation. Our analysis with the Fed staff's FRB/US model suggests that the net effect on growth over the next year is likely to be broadly neutral. We therefore do not expect notable revisions to the committee's growth projections, except some marking to market for 2014. The effects of dollar appreciation and lower oil prices should, however, reinforce each other in terms of their effect on inflation. Headline inflation is likely to come down mechanically and we expect the mid-point of the central tendency for the 2015 headline PCE forecast to come down from 1.75% in September to 1.6%. (However, a larger-than-expected downward revision to headline inflation in 2014 might argue for a smaller, or even positive, revision to 2015 due to base effects.) We also expect a reduction in core inflation by 10bp in 2015.
Q: The economic turmoil in Russia has intensified. Will the FOMC acknowledge these events in the statement?
A: We do not think so. While it is possible that the committee could reintroduce language highlighting that "strains in global financial markets" pose downside risks to the outlook, we think recent developments have not changed the Fed's thinking on global risks in a significant way, and we therefore view this as unlikely. Especially as the dust has yet to settle on recent developments, we think the Fed would probably like to avoid the perception of overreacting to this week's events and potentially sending a bearish signal on growth. In the past, we estimated that the US trade and banking system exposure to EM (including Russia) is fairly small.
Q. What does the Fed think about the recent selloff in high yield bonds?
A: While the recent widening in high yield credit spreads has attracted considerable attention, we do not think the Fed views this development as presenting particular financial stability risks. Indeed, Vice Chairman Stanley Fischer stated as recently as early December that "there are a few areas where risk premia are lower than you would like to see," and the riskiest bonds are one likely suspect for what he was referring to. As a result, it would be odd for the Fed to see the selloff as an especially adverse development. Furthermore, the Fed likely views financial stability risks as primarily stemming from excess leverage and credit growth in the economy as a whole, conditions that are not readily apparent in today's environment.
Q: Will the "dots" come down?
A: We see the dots as subject to two offsetting forces. On the one hand, strong growth and a continued decline in the unemployment rate would tend to push up the dots. On the other hand, the likely reduction in the inflation forecast, the reduction in the structural unemployment rate and the recent market volatility would argue for lower dots. Our baseline expectation is that these effects will offset and leave the dots broadly unchanged. However, we see some downside risk to our projection for the dots. For example, for 2015 we expect a reduction in actual and structural unemployment by 10 basis points (bp) and a reduction of core inflation by 10bp. A standard Taylor rule with a coefficient of 1.5 on inflation would suggest that this set of developments might push the warranted path for the fed funds rate down by about 15bp. In addition, as the more hawkish meeting participants tend to place more emphasis on inflation developments and the inflation outlook, it seems likely that some of the "high side" dots may come down more markedly, while the "dovish consensus" dots might be little changed.
Q: Will there be any dissents?
A: Our baseline is for no dissents. Minneapolis Fed President Kocherlakota dissented in October; despite lodging consecutive dissents in the past, it does not appear that he is willing to dissent multiple times over the same issue.
Q: Will Chair Yellen hold a press conference after every meeting next year?
A: This is possible, and it is likely that the subcommittee on communications has deliberated on this topic. If press conferences were introduced for each meeting, and the committee retained "considerable time," it would open up the possibility of dropping considerable time in January 2015.
Q: Risks to market expectations
A: Our Treasury trading desk recently conducted a survey of client expectations for the December meeting. In line with our own view, the vast majority of respondents expect that "considerable" time will be removed from the statement, and the majority of respondents expect the SEP projection for inflation in 2015 to be downgraded slightly. Most respondents also expect the 5th lowest SEP dot—which we take as a proxy for the "center of gravity" on the committee— to remain unchanged at the end of 2015. The primary area of difference between our own view and clients' views is that under our baseline scenario, once the Fed begins hiking, rate hikes continue at a gradual pace until reaching a terminal rate of around 4%. In contrast, many respondents expected that rate hikes would either be interrupted by a pause of more than two meetings, or the ultimate terminal level of the fed funds rate would be considerably below 4%.
An area of particular interest for the post-meeting press conference will be any discussion of the post-liftoff guidance. Chair Yellen has stressed in past press conferences that the committee intends to follow a “shallow glide path” for the funds rate target given headwinds that are expected to depress the “neutral” funds rate for years to come. Two aspects of recent Fed communication raise the prospect that views on the speed of normalization might be starting to shift. First, the minutes of the October meeting stated that “a number of participants thought that it could soon be helpful to clarify the committee’s likely approach” with regard to the pace of normalization. Second, in a recent speech, New York Fed President Dudley did not reiterate expectations for a “shallow glide path” but instead stressed that the pace of normalization will depend on economic conditions and financial conditions. If markets digest initial Fed tightening as easily as they have digested the asset purchases' withdrawal, a “more aggressive” pace of tightening seems likely. Our forecast remains for the first hike in September 2015, followed by a steeper path of the funds rate than current market pricing.
