September FOMC Preview: A Midstream Meeting

The September FOMC meeting is emblematic of the Powell Fed so far: the rate decision has been so carefully broadcast as to be nearly moot, and investors are mostly focused on the outlook for future rate decisions. In many ways, this meeting has a midstream feel – rates are on the move, important committee membership changes are underway, and debate within the Fed over the outlook is heating up. Market participants would be well advised to savor the no-brainer rate hike, because there may not be many more of them. If the near-term looks clear, the medium-term looks anything but.

What’s at stake

• Confirmation of the nearly universal expectation for a rate hike, to a range of 2.00% to 2.25%. The CME’s Fedwatch tool indicates a market-implied probability of over 90% that the Fed will raise rates by a quarter of a percent.
• The rate outlook: Market expectations have shifted decidedly in favor of a 4th hike in December (now estimated at a nearly 80% probability); 2019 and 2020 are more in focus, given ongoing fiscal stimulus and rising chatter about recession risks. The dot plot should see a slight upward shift, but not enough to move the median dots.
• Another highly-anticipated adjustment to the FOMC statement appears likely, as the Fed continues to set aside its post-crisis tools. The much-discussed phrase about “accommodative” policy looks more likely to be removed than modified.

Rate Hike

• From stronger-than expected economic growth and steady job gains to firming inflation and even wage growth, this rate hike is as close to a no-brainer as it comes for the Fed.
• The background conditions feeding into the rate decision are worth repeating: Real interest rates are still close to zero, fiscal stimulus is ongoing, and both consumer and business sentiment are riding high. If the Fed wants to be ready to effect outright monetary restraint on growth – via a real rate of interest that is not just above zero but above neutral – it needs to keep hiking.
• Of course, views on where the neutral interest rate might lie are also a critical factor, which is why it has received so much discussion from the likes of Chairman Powell, Governor Brainard, and various regional bank presidents.
• Ultimately, it’s a question of how the current committee weighs the upside and downside risks over the next year or two, which depends on views on fiscal policy as much as on interest rates. When will the fiscal stimulus of recent tax cuts and spending increases begin to fade, how fast will the economy grow after that point, and how might trade conflicts affect either growth or inflation? That will inform policy makers’ views on where the short-term neutral real rate lies, and that’s the standard to which they will compare their their rate decisions. The deeper into positive territory rates rise, the more pressing this issue becomes.

Dot Plot

• A few 2018 dotes will rise to suppport the growing consensus that, barring a significant deterioration in the outlook, a fourth hike in 2018 will be warranted.
• The 2019 and 2020 dots will probably drift upward slightly, but not enough to move their medians — implying three hikes in 2019 and just one in 2020. The 2021 dot will likely hold steady at the 2020 level of 3.375%, a fraction of a percentage point above the long-run neutral rate.
• Why? Although there are some significant risks in the medium term, the latest and hardest data have mostly surprised to the upside. Moreover, the Fed has typically chosen to put a bright face on the economy when risks loom, and its central forecasts have tended to exclude low-probability high-impact negative events.
• The dot for the long-run neutral rate is unlikely to rise, because most Fed policy makers see the effect of fiscal stimulus as a short-term matter.
• It’s important to keep in mind that upcoming changes in committee membership could affect future dot plots. There are three pending nominations for governors for the Fed’s Board and a pending appointment for president of the San Francisco Fed. While the expected new policy makers might tip a median dot or two here or there, they are unlikely to shift the broad strokes of the rate outlook.

Economic Forecasts

• GDP forecasts: The 2018 and 2019 forecasts should shift up a bit, since growth has accelerated more than expected, but not 2020 or the long run. The Fed’s traditional models take a dim view of the notion that spending and tax cuts will necessarily lead to faster potential growth, so the new 2021 forecast should fall back toward long-run levels — or a bit lower, given the restrictive interest rates expected to prevail by then.
• Unemployment rate: The 2018 and 2019 forecasts may shift down slightly once again. With growth expected to slow in late 2019 and 2020, and the unemployment rate so far below its estimated neutral level, it will probably be forecast to rise in 2021.
• Inflation: Inflation expectations remain well anchored, and the committee wants to keep them that way, so policy makers’ forecasts will probably remain at 2.1% for 2019-2021. Looming in the background is Powell’s reference at Jackson Hole to doing “whatever it takes” to keep inflation expectations anchored.

FOMC Statement

• Another highly-anticipated development is the removal of the description of current monetary policy as “accommodative.” The July FOMC minutes made it clear that that phrase’s days are numbered.
• Some have been wondering whether the phrase will be removed or modified, but removal seems more likely. The minutes also made clear that the Fed does not want to provide a false sense of precision regarding where the neutral interest rate lies, and merely modifying “accommodative” would beg the question of when it would eventually be removed. If there’s no appetite to extend that conversation and get more specific, why set up expectations for that? Why not just tear off the bandage?
• No major adjustments to the statement’s description of current economic conditions or the outlook appear likely.

Press Conference

• Any of the hot-button topics will be followed closely, notably: the outlook for 2019-2020, recession risk, where the neutral real interest rate might lie (as well as whatever treatment the “accommodative” phrase receives), and what the Fed might do once real rates are arguably close to that neutral level.
• The Powell Doctrine: Powell’s Jackson Hole speech was notable for its skepticism toward estimates of neutral levels for unobservable structural variables, so there will be great curiosity about how Powell expects to proceed over the next 12-15 months. Is the Fed going to dust off “data dependence” or Greenspan’s “wait and see approach” or roll out some new way of framing its decision-making process? It’s wise to take formal economic models with a grain of salt, but the reality is that the Fed can’t get around employing at least an implicit sense of where the neutral rate lies. Otherwise, there would be no judging policy stimulus versus restriction at all. Powell used the term “rough assessment of neutral,” but how wide a band of uncertainty will he and other policy makers assume (as wide as the 95% confidence interval in the Fed’s last Monetary Policy Report?), and how might they proceed as their policy rates enter that band? He probably won’t be willing or able to give much away on this point yet, but it’s the core of what we should all be listening for.
• Asset price versus consumer price inflation: these topics are clearly on Powell’s mind, given his comments at Jackson Hole about “looking beyond inflation for signs of excesses” and the nominations to the Board of an expert on bank regulation (Michelle Bowman) and another on financial stability (Nellie Liang). Powell will surely be tight-lipped here, but perhaps we can learn something about the principles he’s steering by. Is it all about leverage vs. capital, and maturity mismatches? Does he have any thoughts on corporate balance sheets or how to shift from fighting the last war to fighting the *next* war? How might this fit into a Powell Doctrine?