Breaking up (with forward guidance) is hard to do

19 Dec 2018

  • Conflicting signals in FOMC communications play into the narrative of a hawkish Committee
  • The retention of forward guidance on the path of rates, even if watered down, came as a slight hawkish surprise
  • The approach to balance sheet run-off is looking increasingly rigid as investors become more attuned to downside risks to the outlook

On the surface, the outcome of the FOMC meeting and Chairman Powell’s press conference was largely as expected. The FOMC voted to raise the target range for the federal funds rate by 25 basis points, but a weaker external backdrop and tighter financial conditions led a number of Committee participants to revise lower their projected path for the policy rate. As a result, the rate path projected by the median Committee participant shifted lower by 25 basis points over the three-year projection horizon. In addition to the median Committee participant now projecting just 50 basis points of tightening next year, there were other elements of the day’s communications that suggested greater caution around the near-term pace or policy tightening. These include:

  • Slight mark-downs to the median Committee participant’s projection for the longer-run unemployment and federal funds rates. These revisions imply somewhat looser labor market conditions and less distance to a neutral policy setting, relative to the September projections.
  • Downward revision to the median projection for core inflation through 2021.
  • Reference in the statement to the Committee monitoring “global economic and financial developments.”
  • Chairman Powell’s acknowledgement during the press briefing that somewhat soft inflation readings allow the Committee to be patient in raising rates, as well as his emphasis that policy may not need to move into restrictive territory.

Despite the shift down in the projected rate path, market participants appeared to focus on more hawkish elements of the FOMC’s communications, leading to a negative reaction in risk markets and a decline in long-term Treasury yields. For example, investors had largely expected the Committee to remove from the policy statement the last vestige of forward guidance, i.e., the reference to “further gradual increases” in the policy rate. Instead, the language was retained, though watered down. Investors may have interpreted the retention of forward guidance as an indicator that the Committee is inclined to raise rates again in March. When specifically asked whether the Committee could slow the pace of future rate increases, the Chairman stressed that he will be looking to see if incoming data are in line with Committee forecasts, implying that such an outcome would lead to a policy rate increase before long.

Other aspects of the day’s communications may also have been read by investors as hawkish. As was the case in November, the policy statement described economic activity and the labor market as “strong”, while in contrast investors have increasingly focused on signs of moderation in growth as well as additional downside risks. Similarly, Powell certainly mentioned “crosscurrents” such as the global growth backdrop and tighter financial conditions, but was also quick to point out that these developments, “have not fundamentally altered the outlook.”

Another hawkish element to the day’s communications involves the approach to balance sheet runoff. The Chairman was asked whether there are any concerns among Committee participants that runoff is having a negative impact on markets, including credit markets. The Chairman remained faithful to the script that the effects of runoff are small, and “not creating significant problems” in money markets. However, the comments are increasingly out of line with the view of many market participants that run-off is impacting financial conditions, in part through a widening of credit spreads. What is surprising about the Committee’s communications about the balance sheet is the lack of flexibility in approach. The Chairman and other Committee participants have shown a commendable degree of flexibility in their thinking about the longer-run unemployment and policy rates, and have also highlighted uncertainty not only about these longer-run variables but also about their economic projections. Chairman Powell also today noted that he will keep an open mind regarding possible implementation of the counter-cyclical capital buffer for financial institutions. In contrast to such flexible thinking, the approach to balance sheet run-off is striking in its rigidity. If downside risks to the outlook grow, the insistence that runoff has little impact on financial conditions and can remain on auto-pilot will look increasingly at odds with any further downward revisions to the policy rate path.