Five Myths About the Fed
By Com Crocker, Managing Director, Institutional Sales and Trading, Mesirow Financial
I'm not going to spend a lot of time here rehashing the details of Wednesday’s hawkish hold by the Federal Reserve. You don't need me to. Despite what some very smart and highly paid economists believed (not the majority, mind you), it was quite clearly telegraphed.
Instead, I want to focus on some commonly held beliefs about the Fed and dispel them as myths.
Myth 1: The Fed didn't hike rates Wednesday because the recent data has been weak.
It's true, the recent data has tended in the wrong direction, from a dip in payrolls and tick up in unemployment, to a decline in retail sales and a sharp drop in the ISM manufacturing survey. We're not exactly on a roll. The Citi Surprise Index sums up the trend pretty succinctly, having dropped 44 points since late July.
But you wouldn't know it from the Fed's statement yesterday, which included the rather clear message, "The Committee judges that the case for an increase in the federal funds rate has strengthened." That doesn't mean that the Fed isn't data dependent like they claim to be. Rather, it might mean that data dependence doesn't mean what you think it means.
As Chicago Fed President Charles Evans said in a speech last November, data dependence is "evaluating how the new information alters the outlook and the assessment of risks around that outlook." For better or worse, given their forecasting track record, the Fed is always looking forward. In that regard, the "near-term risks to the economic outlook appear roughly balanced" and "the case for [a rate hike] has strengthened." That doesn't sound like a Fed that is overly worried about the number of private payrolls added in August or the recent dip in housing starts.
Myth 2: The September call on whether to hike or not was really close.
Three hawkish dissents! The last time that happened was five years ago, so long ago that former Minneapolis Fed President Narayana Kocherlakota was one of them. Of course, that was before Evans took him to Doves' Peak on a moonlit night and showed him the light.
But no. The discussion was robust (as Governor Daniel Tarullo said it would be in his recent CNBC appearance), and the vote was 7-3. But as they said after Louisville beat up on FSU to the tune of 63-20, it wasn't even that close. Any remaining chance that the Fed would hike this week went out the window when Governors Tarullo and Lael Brainard spoke in the final days prior to the Fed's blackout period and were as dovish as ever. Brainard in particular laid out a five-point manifesto to "prudence in the removal of policy accommodation."
When Brainard was announced as last Monday's keynote speaker at The Chicago Council on Global Affairs, many wondered if she would use the opportunity to move the market's needle toward a hike this week. Such speculation, on the back of ECB President Mario Draghi's seemingly wavering in his commitment to further policy accommodation, contributed to a global stock and bond market selloff that sent many scurrying to the hills fearing the end was near. This is sound Fed-watching logic: The Fed is loath to surprise the markets and thus would look to prepare the markets if there was indeed a possibility that they would hike. The final day before the blackout period was the last chance to do so, and who better to move the needle than the Fed's biggest dove.
Hawks saying hawkish things is noise, but when a dove says hawkish things, well then we should all sit up straight and pay attention. Of course, those that know and understand Brainard knew how comical this notion was. She was no more likely to tote the hawks' water than the Hamburglar is to turn vegan. But where a few Fed-watchers slipped was in failing to apply their same logic in reverse: If the Fed passed on the opportunity to prepare the markets for a hike (and read Brainard's speech - it was a pretty emphatic pass: http://tinyurl.com/zk5t9bf), then they weren't hiking.
CNBC had a segment Thursday morning called, "Fear of a Fed Surprise was Real." The unspoken punchline is that no one was more fearful of surprising the markets than the Fed itself. Again, it simply wasn't going to happen.
But what about all the hawks? What about Vice Chair Stanley Fischer? How can you possibly have any confidence in what they're going to do? Which brings me to...
Myth 3: The Fed is atrocious at communicating.
Ok, clearly this one has some basis in truth. I mean, come on - they're not always great and it gets a little overwhelming and confusing at times, what with 17 different voices all speaking their own minds. But the fact is we've gotten really bad at listening, and more often than not lately, the fault lies not with the Fed but with us. By we/us, I mean the street, investors, the financial press, everybody. People simply aren't paying attention anymore and, rather than listening to or reading the Fed's actual words, they react to typically misleading and, at times, outright erroneous headlines. Take the dots for example. Here's where regular readers roll their eyes and say, "No, not the dots again!" If that's you, feel free to skip the next paragraph, but it's a pretty stark example of how little attention people are paying and the erroneous conclusions they jump to.
Last December, as you'll no doubt recall, the Fed hiked. No surprise as they telegraphed it pretty clearly ahead of time (as they are wont to do - see Myth 2). Most expected a 'dovish hike' that would include a lowering of their guidance for further hikes down the road, in part to reflect reality and in part to help the medicine go down. But as you may recall from the headlines that immediately followed, "The Fed's Dot Plot Didn't Move!"
Indeed, the median dot implied four hikes in 2016, same as it had in the prior Summary of Economic Projections (SEP) three months prior.1 The dreaded 'hawkish hike' contributed to a global market selloff that continued into the new year, with stocks and commodities not finding their lows until late January and early February. But even a cursory glance at the dots told a vastly different story and highlighted the limitations of focusing only on the median. The median dot didn't move but the mean dot moved quite a bit, falling by 29bps, or more than one full hike (from ~4½ hikes in the September 2015, SEP to ~3½ hikes in December.2 Fast forward to the next SEP, released with the March FOMC Statement. The mean dot dropped another 26bps (from 3½ hikes to 2½), while the median caught up to the December move and dropped from four hikes to two.3 Once again, markets focused only on the median, this time running with the dovish surprise narrative. Commodities rallied over 3% in 48 hours.4 S&Ps rallied from below 2000 prior to that meeting, territory they've only revisited in the days following the Brexit vote.
Another example of simply not paying attention is the widely held belief that Fischer called for two rate hikes this year in his interview with Steve Liesman on CNBC at the Jackson Hole Symposium just a few weeks ago. Fischer is the most hawkish of the permanent voters on the FOMC, and he's a critic of forward guidance, preferring to stir the pot, leave markets guessing and invite a little healthy volatility back into the markets. (Wow, if only he had been born in the U.S., I might write him in for president!) His comments should always be viewed with this lens. But more to the point, he never said what people think he said.
What Fischer DID was to give a vague answer to a more specific question. Asked if markets should be prepared for a possible September hike "and for more than one policy tightening before year end," Fischer deferred to Chair Janet Yellen's prior remarks and said he thought they were consistent with the questions, a comment he further watered down with a caveat about data dependency. He could have given that same answer to just about any question. Or he could have just as easily said, "All meetings are live," Fed boilerplate which markets would have recognized and quickly ignored. And yet last Thursday morning, Janus Capital Management portfolio manager Bill Gross said, "After hawkish talk at Jackson Hole from Yellen and Stan Fischer, who even said there'd be two hikes in 2016..."5 Except that he never said that.
A critical factor muddling the market's ability to understand the Fed and what they are likely to do is that too many people confuse thinking about what the Fed SHOULD do with thinking about what the Fed WILL do. That leads to hearing what we want to hear instead of what is being said. Unless you have a direct call into Yellen, any time spent on the former is wasted and likely distorting your ability to determine the latter. Sorry, but no one cares what you think the Fed should do. Let it go.
Myth 4: The Fed has turned hawkish.
First of all, while the hawks on the Fed are growing in volume (both in number and in noise level), it remains Yellen's Fed. The same Yellen gave this speech back in March 2014, when she brought out three "real people behind the statistics, struggling to get by and eager for the opportunity to build better lives:" http://tinyurl.com/gva92mh. It's more like a stump speech than a speech on monetary policy.
More to the point, the unemployment rate is currently below 5%, YoY core CPI is 2.3% and YoY core PCE stands at 1.6% (expected to have reached 1.7% in August when it is soon released). But the Fed has hiked fed funds just once after holding them near zero for seven years, and is struggling to work up the nerve to hike a second time. To say nothing of the Fed's balance sheet, which stands at close to $4.5trn. Now, as the Fed has pointed out repeatedly, given the low level of the natural rate of interest (aka r*) monetary policy hasn't been quite as accommodative as we might have originally thought. But does that mean the Fed isn't as dovish as we thought, or is that a dovish Fed playing for more time before normalizing rates?
Regardless, the better question may be, if the Fed is so dovish, why are they so eager to hike at all? Which leads us to...
Myth 5: The Fed wants to hike in order to make room to ease again in the next recession.
This is a common argument but simply isn't how the Fed thinks, even the hawks. Why risk hastening or even triggering the next recession just to make more room to ease when that recession hits? It makes no sense, particularly given that "policy options are asymmetric," as Brainard argued. As the minutes have also stated, "with the target range of the federal funds rate only slightly above zero," asymmetry of the Fed's policy response options makes it "prudent to wait for additional information regarding the underlying strength of economic activity."
Of course, not all members of the Fed are dovish. The majority of regional Fed presidents are hawkish and ready to hike now, including yesterday's three dissenters. But why are some of the doves on the board also so eager to hike, if not exactly ready to do so as yesterday confirmed? The short answer is, for the Fed to claim victory, as well as to keep forward guidance, ZIRP and QE in their toolbox for future use, the Fed must first successfully unwind us from those same policies. They can't claim that extraordinarily accommodative monetary policy worked while the economy remains dependent on those same policies. If they can successfully extricate themselves from such policies, they would be the first central bank to do so. That remains their goal, one that seems forever just beyond their reach.
This is not meant to endorse the Fed or past, current or future monetary policy in any way. It doesn't matter what I think. It doesn't matter what you think, either. Sorry. What matters is what the Fed thinks, and how the market responds to it. Once you focus on that, predicting the Fed and trading the market's reaction to it becomes easier. Not easy, mind you. Just easier.
1. Federal Reserve December 2015 SEP Dot Plot
Federal Reserve September 2015 SEP Dot Plot
2. Calculated mean rates for each of the previous two Dot Plots, which are then converted to an implied number of rate hikes.
Of note is that at the September 2015 FOMC meeting, which was Kocherlakota’s last prior to resigning, he indicated a preference for a cut to negative rates, followed by no rate hikes in
2016 (leaving rates negative). This was widely dubbed a “protest dot” and was generally ignored. Kocherlakota was no longer a member of the Fed at the December 2015 meeting, and
thus his dot was no longer there. In comparing the dot plots between the two meetings, I excluded his dot from the September 2015 Dot Plot. Including his dot decreases the difference in
the means between the two meetings to 19bps (just below one full hike) from the 29bps I included in the analysis (just above one hike).
3. Federal Reserve March 2016 SEP Dot Plot
Federal Reserve December 2015 SEP Dot Plot
4. Bloomberg Commodity Index