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12 16 2015 | by Victor Xing | Central Banks

December FOMC: “End of an extraordinary 7-year period”

The Federal Open Market Committee (FOMC) raised the federal funds rate target range to 1/2 percent at its December meeting, officially “lifted off” rates from its zero lower-bound, a level that had been in-place since Dec 17, 2008 (Fed Cuts Key Rate to Record Low).
Today’s move was well-telegraphed and widely expected (as seen in Federal Reserve Communications Roundup for December 2nd, 2015), with market reaction appropriately muted.  Nevertheless, the meeting still provided market participants with new languages on the latest Federal Reserve thinking, as well as nuances on its operational policy tools and considerations on future policy paths.

Executive summary of the December FOMC

  • Effective Dec 17th 2015, New York Fed’s trading desk (“the Desk”) will use its now operational Overnight Reverse Repurchase Agreement (ON RRP) policy tool to create a 0.25% floor of the new 0.25% – 0.50% fed funds rate target range, and the interest on excess reserves (IOER) rate will serve as the upper-bound
    • The efficacy of the ON RRP program under a fully operational context will be under close scrutiny
    • $2 trillion of Treasury securities will be available for the operation, with a limit of $30 billion per counterparty
  • The FOMC Statement, SEP, and press conference were mostly on expectations with hints of cautious policy (a dovish “liftoff”)
  • Two new keywords were introduced in the Statement, suggesting the FED will remain cautious about its inflation projection, as well as maintaining its Agency MBS Reinvestment Purchases and Treasury Rollovers program for a considerable period of time
    • Carefully monitor” realized inflation and inflation expectations: continuous assessment of FED’s inflation outlook on whether behaviors of inflation (such as factors currently deemed transient) are inline with FED’s projection or warrant a different perspective
    • Continue with SOMA reinvestment program until policy normalization is “well under way“:  there is little clarity on what “well under way” means, but Yellen’s comments suggest it is data dependent, and the current status quo will continue for some time barring data surprises
  • The FOMC expected (and actively encouraged) the recent tightening of financial conditions (to partly price-in today’s decision), and future “unanticipated changes” in financial conditions will result in FED policy response.  As usual, the FED will look through short-term volatility events
  • Stabilization in the price of oil will result in its impacts on inflation to “wash out” – oil price doesn’t need to rise for its dis-inflationary effects to wane
Additional links:
End of summary

Detailed breakdown of the December FOMC for FED watchers

The December meeting was a quarterly meeting with SEP and press conference with the following segments
  1. Summary of Economic Projections (SEP) and FOMC Statement(released at 11:00am PT, 2:00pm ET)
  2. Chair Yellen’s press conference and Q&A (11:30am PT, 2:30pm PT)

 

Summary of Economic Projections (SEP)

The December SEP saw a few dovish changes, but markets had already anticipated today’s event as a “dovish hike” – policy normalization with extra cautious assurance to prevent markets from extrapolating today’s move as the beginning of a mechanical path.  Given the SEP is part of the Federal Reserve’s communication tool, the small downward revisions are not surprising.
Changes between the September and December FOMC “dot plot,” or “expected level of year-end rates” by each FOMC participants – the 12 Federal Reserve Bank Presidents as well as five Governors from the Board of Governors, is below: (source: Business Insider)
December 2015 FOMC "Dot Plot"
There are several ways to look at the “dot plot”
  • Some market participants prefer the “median” level of each given year to calculate the “path” of future policy rates
  • Others would focus on the “7th lowest dot,” which would represent Chair Yellen (more dovish members being: Minneapolis Fed President Kocherlakota, Chicago Fed President Evans, Governor Brainard, Governor Tarullo, Boston Fed President Rosengren,  and New York Fed President Dudley)
In term of median “dot” level changes:
  • Median funds rate at 1.4% by end of 2016, unchanged vs. Sept
  • Median funds rate at 2.4% by end of 2017 vs. 2.6% in Sept
  • Median funds rate at 3.3% by end of 2018 vs. 3.4% in Sept
  • Median long-run funds rate unchanged at 3.5%
Highlight of economic projections being NAIRU at 4.8-5.0% vs. 4.9-5.2% in September (dovish, but not unexpected):
December 2015 FOMC SEP

FOMC Statement

Labor market conditions and inflation: the Statement acknowledged improvements in labor market conditions with under-utilization diminished “appreciably.”  However, the FOMC also recognized that some survey-based measure of longer-term inflation have “edged down.” (source: WSJ FOMC Statement Tracker)
December 2015 FOMC Statement
The following section laid out the exact rate hike language:
December 2015 FOMC Statement
There are two key points in the following paragraph:
  • Carefully monitor actual and expected progress toward [FED’s] inflation goal” – the FOMC will be watching for signs if dis-inflationary pressure is no longer “transient”
  • “It anticipates doing so [in buying bonds as part of the FED’s Agency MBS Reinvestment Purchases and Treasury Rollovers program] until normalization of the level of the federal funds rate is well under way” – the reinvestment program is not stopping anytime soon, and investors will be paying close attention to interpretations on rate hike being “well under way”
December 2015 FOMC Statement

FOMC Press conference with Q&A

There were some interesting Q&A exchanges on FED’s view on oil, its reaction function on financial conditions, as well as the aforementioned keywords on inflation and SOMA reinvestment program.
Chair Yellen began by giving an update on the FED’s dual mandate:
Since March, the committee has stated that it would raise the target range for the federal funds rate when it had seen further improvement in the labor market, and was reasonably confident that inflation would move back to its 2 percent objective over the medium term.
In our judgment, these two criteria have now been satisfied. The labor market has clearly shown significant further improvement toward our objective of maximum employment. So far this year, a total of 2.3 million jobs have been added to the economy, and over the most recent three months, job gains have averaged an estimated 208,000 per month — 218,000 per month, similar to the average pace since the beginning of the year. The unemployment rate at 5 percent in November is down 6/10ths of a percentage point from the end of last year, and is close to the median of FOMC participants, estimates of its longer run normal level.
A broader measure of unemployment that includes individuals who want and are available to work, but have not actively searched recently, and people who are working part time but would rather work full time, also has shown solid improvement. That said, some cyclical weakness likely remains. The labor force participation rate is still below estimates of its demographic trend. Involuntary part time employment remains somewhat elevated. And wage growth has yet to show a sustained pickup.
The anticipation of ongoing economic growth and additional improvement in labor market conditions is an important factor underpinning the committee’s confidence that inflation will return to our 2 percent objective over the medium term. Overall consumer price inflation as measured by the price index for personal consumption expenditures, was only one quarter of a percent over the 12 months ending in October.
However, much of the shortfall from our 2 percent objective reflected the sharp declines in industry prices since the middle of last year, and the effects of these declines should dissipate over time.
The appreciation of the dollar has also weighed on inflation, by holding down import prices. As these transitory influences fade, and as the labor market strengthens further, the committee expects inflation to rise to 2 percent over the medium term.
The committee’s confidence in the inflation outlook rests importantly on its judgment that longer run inflation expectations remain well anchored. In this regard, although some survey measures of longer run expectations have edged down, overall there have been reasonably stable.
Market-based measures of inflation compensation remain near historically low levels, although the declines in these measures over the past year and a half may reflect changes in risk and liquidity premiums, rather than an outright decline in inflation expectations.
Once the Q&A began, John Hilsenrath from the WSJ immediately tried to tease out what the FED meant by “carefully monitor,” as in “carefully monitor actual and expected progress toward … inflation goal” in the Statement.  It is a new language, and it is open to interpretation.  The response: to determine if certain disinflation catalysts are indeed transient in nature, but that also doesn’t mean the FED needs to see a rapid rise in inflation before raising rates again.  The FED is essentially trying to determine if its inflation projection is correct.
>> JOHN HILSENRATH: John Hilsenrath from the Wall Street Journal. The sentence in your statement about gradual increases, in that section, the committee says that it will carefully monitor progress, actual and expected progress on inflation. That is going to read like some kind of code to a lot of people on Wall Street. Can you describe what do you mean when you say, carefully monitor? And specifically, with regard to what you do next, do you need to see inflation actually rise at this point, in order to raise interest rates again?
>> CHAIR JANET YELLEN: Well, we recognize that inflation is well below our 2 percent goal. The entire committee is committed to achieving our 2 percent inflation objective over the medium term. Just as we want to make sure that inflation doesn’t persist at levels above our 2 percent objective, the committee is equally committed, this is a symmetric goal, and the committee is equally committed to not allowing inflation to persist below our 2 percent objective.
Now, I’ve tried to explain in many of my — and many of my colleagues have as well why we have reasonable confidence that inflation will move up over time, and the committee declared it had reasonable confidence. Nevertheless, that is a forecast. We really need to monitor over time actual inflation performance to make sure that it is conforming, it is evolving, in the manner that we expect.
So it doesn’t mean that we need to see inflation reach 2 percent before moving again, but we have expectations for how inflation will behave, and were we to find that the underlying theory is not bearing out, that it is not behaving in the manner that we expect, and that it doesn’t look like the shortfall is transitory and disappearing with tighter labor markets, that would certainly give us pause. And we have indicated that we are reasonably close, not quite there, but reasonably close to achieving our maximum employment objective.
But we have a significant shortfall on inflation. So we are calling attention to the importance of verifying that things evolve in line with our forecasts.
>> JOHN HILSENRATH: To follow up, do you need to see it rise? Not necessarily get to the 2 percent goal, but in order to move again, do you want to see inflation measures actually moving higher?
>> CHAIR JANET YELLEN: I’m not going to give you a simple formula for what we need to see on the inflation front, in order to raise rates again. We will also be looking at the path of employment as well as the path for inflation.
But if incoming data were, led us to call into question the inflation forecast that we have set out, and that could be a variety of different kinds of evidence, that would certainly give the committee pause. But I don’t want to say there is a simple benchmark.
The committee expects inflation over the next year at the median expectation is for inflation to be running about 1.6 percent. And both core and headline, so we do expects it to be moving up, but we don’t expect it to reach 2 percent.
Next, Craig Torres from Bloomberg asked Yellen about prices of oil, and that its negative impact on inflation has been quite long and not quite “transitory.”  Yellen’s response: oil doesn’t have to rebound to higher levels in order for its transitory dis-inflationary effects to wane.
>> CRAIG TORRES: Hi, madame Chair. Craig from Bloomberg. I’d like to follow John’s question. The way the committee describes inflation, well, there is this transitory language, I’d like to point out that oil prices today are at 36 and on June 15, they were $60.
This transitory which first appeared in the statement in December, I believe, is lasting a long time, maybe longer than many people’s definition of transitory, and it could go on.
Second, I really wonder if the committee knows how quickly wage increases or labor market tightness transfers into higher prices. That too is also a forecast.
So, my question, what will you be willing to do if you don’t see progress toward 2 percent inflation? We have missed the target for three years. And what would you be willing to do? And second, would you allow inflation to bounce around between 2 and 3 percent, the way you have allowed it to move under 2 percent over the past several years? Thanks.
>> CHAIR JANET YELLEN: First, let me say with respect to oil prices, I have been surprised by the further downward movement in oil prices. But we do not need to see oil prices rebound to higher levels in order for the impact on inflation to wash out.
So all they need to do is stabilize. I believe there is some limit below which oil prices are unlikely to rise. If we look — to fall. If we look at market expectations, market expectations are for stabilization, and then some gradual upward movement.
So, I certainly grant that we have had a series of shocks pushing them down. But we are not looking for them to revert back to higher levels that they were at, merely to stabilize.
I would point out, you asked me would we tolerate overshoots. For a number of years between 2004 and 2008, we had a series of increases in oil prices that, for a series of years, raised inflation above, again, we didn’t have a 2 percent objective then, but raised it above 2 percent. And we judged those increases to be transitory as well, and looked through them. We do monitor inflation expectations very carefully. If we saw in a meaningful way that inflation expectations were either moving, moving up in a way that made them seem unanchored or down, that would be of concern.
And we have called attention to some slight downward movements in survey measures. We are watching that. But I still judge that inflation expectations are reasonably well anchored.
So yes, we have tolerated inflation shortfalls that we thought would disappear over the medium term, just as we did overshoots of inflation that we also judged to be transitory.
But we do need to monitor inflation very carefully, because if energy prices and the dollar were to stabilize, import prices, our expectation is that both headline and core inflation would move up. And if we failed to see that occurring in the manner that we expect, of course we would need to take further action to reconsider the outlook and to put in place appropriate policy.
The big newspaper from district 2 asked Chair Yellen about New York Fed President Dudley’s comment on financial conditions, and if financial conditions doesn’t tighten appropriately, would the FED “do more?”  Yellen’s response: FED will respond to “unanticipated changes” in financial conditions but will look through short-term volatility events.  More over, Yellen’s comment showed that the FED is aware of tighter financial conditions in response to its prior communications, and that tightening is welcomed by policymakers.
>> NEW YORK TIMES: Bill Dudley talked about the need for the fed to adjust policy based on the responsiveness of financial markets, as you begin to increase rates. You didn’t talk about that today. Is it a point that you agree and if so, what is it you are looking for, how will you judge whether financial markets are accepting and transmitting these changes?
>> CHAIR JANET YELLEN: There are a number of different channels through which monetary policy is transmitted to spending decisions, the behavior of longer term, longer term interest rates, short-term interest rates matter. The value of asset prices, and the exchange rate, also these are transmission channels.
We wouldn’t be focused on short-term financial volatility, but were there unanticipated changes in financial conditions, that were persistent, and we judge to affect the outlook, we would of course have to take those into account. We will watch financial developments.
But what we are looking at here is the longer term economic outlook, are we seeing persistent changes in financial market conditions that would have a bearing, a significant bearing on the outlook that we would need to take account in form lating appropriate policy — formulating appropriate policy, yes, we would but it’s not short term volatility in markets.
>> You didn’t see changes, you would be concerned and have to move more quickly. Are you concerned that if markets don’t tighten sufficiently, you may need to do more?
>> CHAIR JANET YELLEN: Well, look, this is not an unanticipated policy move. And we have been trying to explain what our policy strategy is. So it’s not as though I’m expecting to see a marked immediate reaction in financial markets, expectations about fed policy have been built into the structure of financial market price.
But, we obviously will track carefully the behavior of both short and longer term interest rates, the dollar and asset prices, and if they move in persistent and significant ways, that are out of line with the expectations that we have, then of course we will take those into account.
Next, FT highlighted FOMC Statement’s comment on maintaining SOMA reinvestment until policy normalization is “well under way,” but the FOMC is still formulating policy on its reinvestment program, which is expected to last for some time under its current form.  Yellen did not clarify on what “well under way” means other than that it is data dependent, and the FED is still looking into the reinvestment program.
>> SAM FLEMING: Sam Fleming from the financial times. Could I ask about the balance sheet policy you are adopting today. You said you want to keep a large balance sheet until normalization is well under way. Could you explain first of all why you anticipate that being appropriate? What does well under way mean in terms of normalization? Longer term, what are your views on the idea that the fed might need to have a larger balance sheet than historically over the longer term?
>> CHAIR JANET YELLEN: Well, in our normalization principles which are in effect, the committee stated that we eventually want to operate with a much smaller balance sheet than we have at present.
We would reduce the size of the balance sheet to essentially whatever size we needed to manage monetary policy effective, in an effective and efficient way. Now, a lot has changed since prefinancial crisis in terms of the financial system.
And we are studying, we are engaging in a project at this time to consider what our long run operating framework should look like. So I can’t tell you exactly what size of balance sheet we will determine is the best to operate in an efficient and effective manner. It might be somewhat larger than the very tiny quantity of reserves that we had in precrisis. We have not determined that.
We have also said that we will, we expect to reduce the size of our balance sheet over time by cease diminishing or ceasing entirely reinvestments. Beyond that, we haven’t given additional guidance, other than to say that the timing of reductions in reinvestment will depend on economic and financial conditions.
And I suppose that additional guidance we are giving told when we say well under way, we want to see, as I mentioned, there are a number of considerations, and the committee has made no further decisions about this. But as we have discussed, the factors that will be relevant to the decision, one factor that we have talked about is the desirability of having some scope to respond to an adverse shock to the economy by lowering the federal funds rate.
And so it would be nice to have a buffer in terms of having raised the federal funds rate, to a certain extent to give us some meaningful scope to respond. Now, I don’t have in mind here any particular level of the federal funds rate. It would depend on the entire economic outlook, how robust the economy is.
But that is an important consideration for the committee, and it means that it’s, this is not something that we expect to be turning to, to cease reinvestment very quickly.
Original Quora article

Next article12 15 2015 | by Victor Xing | Economics

November Consumer Price Index (CPI): mostly on-consensus