"Some of the participants, but not all of the participants, did incorporate some assumption of a change in fiscal policy into their projections. And that may have been a factor that was one of several that occasioned these shifts. But I want to emphasize that the shifts that you see here are really very tiny."
- Janet Yellen, December 14, 2016 press conference
Ahead of today's Fed meeting, the Wall Street consensus was that no matter what Janet Yellen said, whether it was a dovish, neutral or hawkish hike, the market reaction would be positive - just look at Torsten Slok's prediction from yesterday. It was disappointed.
Why? For two main reasons.
As SocGen's Omair Sharif explains in a post-FOMC note, the Fed spent most of the year revising down its rate projections, coming into the year anticipating four hikes, only to see those projections upended by market and economic events. By September, three officials saw no hikes this year, up from just one in June. Meanwhile, the market-implied probability of a December hike was only around 60% after the September meeting, with market participants debating whether or not the Fed could even hike this year. However, since that meeting, the data flow was supportive of a hike, and Fed officials expressed growing comfort with achieving their dual mandate. That led to the December hike becoming fully priced in, and today the Fed delivered, as expected.
As such, the hike itself was an anticlimactic event.
However, as we previewed repeatedly over the day, the most pressing issue for market participants was whether or not officials would revise their rate projections for 2017 and beyond.
Key question: how many hikes in 2017— zerohedge (@zerohedge) December 14, 2016
This is where SocGen, and many others, admit they were "surprised" by the Fed adding an extra hike in 2017, with the median dot now showing three hikes next year versus two in September.
In her press conference, Chair Yellen noted that only some participants changed their outlook for rates in 2017, but it was enough to move the needle on the median. She also indicated that those who moved their rate hike projections higher weighed several factors, including a somewhat lower unemployment rate in the December projections than in September, somewhat higher inflation than previously projected, and she also stated that “some did incorporate some assumption of a change in fiscal policy, and that may have been a factor...”
Adding to the confusion, SocGen notes that given that a number of Fed speakers post-election indicated that they would not change their forward-looking views until they actually saw what fiscal policies would be implemented, this too "was is a surprise to us."
It gets more interesting.
Yellen was also asked several times about fiscal policy, but she largely avoided discussing how monetary policy might react to changes in fiscal policy. One reporter asked her why she sounded a note of caution on fiscal policy in her recent JEC testimony when she and Bernanke had been clamoring for help from fiscal policy in the past. Yellen noted that both she and Bernanke had wanted more from fiscal policy in the past, but that was a time when the economy was noticeably further away from full employment than it is today. Indeed, as both we - and Goldman - noted earlier, the slight change from noting that accommodative policy could further “strengthen” the labor market as opposed to help improve it, suggests that Yellen is comfortable with the idea that the economy is at or near full employment.
We captured this in a post earlier in which we explained that "Stocks Slip As Yellen Says Trump Fiscal Boost "Not Needed", May Not Improve Productivity" in which Yellen hinted that the US economy ihas reached a level where any incremental fiscal stimulus - i.e., the bread and butter of the Trump campaign - is not only not needed, but could force the Fed to accelerate the pace of rate hikes.
Here are the two key exchanges, the first of which with Steve Liesman in which he asked the $6.4 trillion question: if there is a rush of fiscal policy, will the Fed have to hike faster?
Steve Liesman, CNBC: If there was a rush of fiscal policy, that did not increase the productive capacity of the economy, would that mean the Federal Reserve would have to move more quickly with raising rates?
Janet Yellen: It is something I can't generalize about, because while it would be desirable to have tax policies that do increase the productive capacity of the economy, an increase in the pace of productivity change is one of the factors that does affect the economy's neutral rate, a boost to productivity could spur investment. As we have been saying, we estimate that the value of the neutral federal funds rate is quite low, and one of the reasons for that is slow productivity growth. So it's very hard to generalize about it, because it could affect that neutral rate.
While Yellen was tentative, a key follow up question whiuch asked how much stimulus can be injected "before we run the risk of overheating", provided the needed answer:
Question from the Washington Post: I'm curious, you and your predecessor had both at times called for more fiscal stimulus, to help with the outlook, the growth outlook. I'm wondering how much do you judge the economy has capacity for fiscal stimulus right now? It's a version of Steve's question but I think we are trying to get at, how much can happen before we run the risk of overheating?
Janet Yellen: Well, I believe my predecessor and I called for fiscal stimulus when the unemployment rate was substantially higher than it is now. So with a 4.6 percent unemployment, and a solid labor market, there may be some additional slack in labor markets, but I would judge that the degree of slack has diminished. So I would say at this point that fiscal policy is not obviously needed to provide stimulus to help us get back to full employment.
However, lest it be interpreted that Yellen was telling Trump how to govern, she quickly said the following:
But nevertheless, let me be careful that I am not trying to provide advice to the new administration or to Congress as to what is the appropriate stance of policy. There are many considerations that Congress needs to take account of, and many bases for justifying changing fiscal policy. I've continued to highlight the importance of spurring productivity growth, that I think that would be something that is beneficial for the economy.
But the most amusing notice from Yellen was that US debt may now be too high to accommodate a $5 trillion increase to the already record debt level:
Of course, it's also important for congress to take account of the fact that, as our population ages, that the debt to GDP ratio is projected to rise, and that needs to continue to be taken into account. So there are many factors that I think should enter into such decisions.
In short: while the Fed was begging the government to step in with fiscal stimulus for year upon years, now that the US has an unprecedented amount of fast food workers and minimum wage employees who are benefiting from recent minimum wage hikes, this is no longer the case.
None other than former Fed Vice Chair Alan Blinder confirmed it on Bloomberg TV after the Fed statement when he said that monetary policy officials were “practically begging” for fiscal-side help for years and Republicans refused to deliver, but with Donald Trump elected as president there’s suddenly support for stimulus, which is no longer needed because "we are in the neighborhood of full employment".
Of course, he is entitled to his opinion, and one may counter that there is a huge need for productivity-boosting fiscal stimulus when 95 million Americans are out of the workforce, and when the marginal job creation has been for minimum wage positions, mostly waiters and bartenders, however with the economy running at the Fed's definition of "full employment" and near 2% inflation, would require further tightening of monetary policy from the Fed to avoid overheating according to the Fed's two two key mandate metrics.
Blinder confirmed as much when he said that If the "economy is put on a sugar high by fiscal expansion, unemployment rate falls below stable level, inflation accelerates, Fed could raise rates more than it’s predicting."
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Other analysts also noted the significant shift in sentiment.
Deutsche Bank's Alan Ruskin told Bloomberg that not all members of FOMC were ready to include expectations of fiscal stimulus when calculating their rate forecasts, so the Fed's dots will go even higher once more specifics about “Trumponomics” are priced in. Read: more hikes. Ruskin also noted that "finally the market is moving toward the dots now, fortuitously or otherwise” and added that “this is definitely a change in tune” as the market has previously shown “clear independence” relative to Fed forecasts.
BofA's Michelle Meyer, who is expecting just one rate hike in 2017, also admitted that risks to the forecast are “clearly” to upside, leading to tighter conditions.
But the best assessment came from Allianz' analyst John Bredemus, who told Bloomberg that "the Fed has been moving down toward the market for quite a while now, and then all of a sudden they reverse course, and the market is looking at it saying ‘maybe the party’s over’.” He added that "today was a reaction to inflation moving up, and the fact that the Fed will raise rates to prevent it from going up too much."
Just how much, will depend on Trump's policies.
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And there it is: that modest, barely noticed shift in the narrative, which has transformed the Trump plan for "massive" fiscal stimulus from the one thing the market could not get enough of, to a potential catalyst for an accelerated tightening cycle and far more rate hikes by the Fed than the market is pricing in at this moment.
It is also what caused today's selloff, because slowly the market is realizing that the "hail mary" policy may be trapped: on one hand, Congress Republicans may block Trump from getting much if any of his desired stimulus, something which even JPM admitted this morning is the biggest risk for the market; on the other, should Trump get what he wants, the Fed will - as Yellen implicitly warned today - have to hike even more aggressively, leading to predictable consequences for the stock market.
So while it remains unclear if Yellen's press conference has converted Trump from a market hero to a market villain, one whose every spending proposal will now be closely analyzed by the market to see if it adds to inflation and thus, to higher rates, keep a close eye on the US Dollar and yields: should these continue their surge, financial conditions will quickly collapse, and with it the Fed's carefully shifted narrative. As for stocks, it may well be that the Barrons' curse has indeed struck again...