I have never cared for the expressions ‘hawkish’ and ‘dovish’ to describe monetary policy communications such as those by the US Federal Reserve’s Federal Open Market Committee (click here to find out more about the FOMC) since I think the terms fail to distinguish between two distinct and important concepts: (1) changes to a policy committee’s reaction function, i.e., the appropriate policy stance for a given state of the economy (click here to find out more about the reaction function); and (2) a change in the policy outlook driven by a change in projections for the US economy, even as the reaction function remains unchanged.
FOMC: FULL STEAM AHEAD
Many will likely qualify the FOMC’s latest statement as ‘hawkish’, but what does that mean? Has the policy committee’s reaction function changed? Or is its outlook for the economy somewhat more optimistic than what investors expect? To my reading, it is the latter case: the FOMC reaffirmed its relatively upbeat expectations and shrugged off potential downside inflation risks.
Beyond the decision to end asset purchases (click here to find out more), its relatively upbeat assessment can be seen in a number of elements of the statement:
• An improved assessment of the labour market. The FOMC no longer said underutilisation of labour resources “remains significant” and instead noted “underutilisation of labour resources is gradually diminishing”. It believes there is sufficient underlying strength in the economy to allow for the labour market to continue to improve without additional asset purchases.
• It no longer said “fiscal policy is restraining economic growth”. This acknowledges that the fiscal constraint from sequestration – one of the main headwinds to growth – has now faded.
• A lack of significant concern over the disinflationary impact of lower energy prices and ‘other factors’ (i.e., US dollar appreciation). The FOMC viewed cheaper oil and other factors as having only a temporary effect on inflation.
‘CONSIDERABLE TIME’ STILL FIGURES IN FED’S FORWARD GUIDANCE…
As expected, the rate-setting committee reiterated that it will still likely be a ‘considerable time’ before the first policy rate increase. It added two rather tortured sentences that state the obvious, i.e., the forward guidance is conditioned on the pace of progress towards the committee’s dual inflation and employment mandate.
It is tempting to view this as watering down the forward guidance, but I do not believe this is the correct interpretation. Chair Janet Yellen has on many occasions stressed the conditional nature of the forward guidance. If anything, by emphasising the flexibility of the forward guidance, the Committee has the luxury of leaving the “considerable time” language in the statement for longer. For example, if the first rate increase occurs next June, as we continue to expect, it would not be out of keeping to refer to “considerable time” at least until the January meeting, particularly given the committee’s risk management approach to policy.
…BUT ‘DOWNSIDE RISKS’ TAKES A BACKSEAT IN FOMC STATEMENT
If I could quibble with recent Fed communications, it would be with the inconsistency between the latest statement wording and the September meeting minutes. Those minutes highlighted downside risks such as slow growth abroad and dollar appreciation and led many investors to push out their expectations for the timing of the first rate increase. The minutes also likely encouraged market discussion of a possible continuation of QE until the December FOMC meeting.
In contrast to the minutes, the statement contained little to no acknowledgement of downside risks. The minutes appear to have mischaracterised the concerns over the risks to growth and inflation.
For our part, our modal expectations for a first rate hike next June remain unchanged. However, the risks to this view have shifted somewhat. Previously, we had seen a meaningful chance that lift-off could occur as early as March. However, we now see the risks around our June forecast as more evenly balanced, given the disinflationary effects of low energy prices and a stronger dollar.