Fed Drops Reference To Further Gradual Hikes, Says Prepared To Adjust Balance Sheet Runoff Plan

Ok, let’s see if the Fed can “out-dove” itself.

We’ve previewed the January Fed meeting on at least a half-dozen occasions over the past week. The bottom line is that everyone is looking to see how they decide to reiterate the recent dovish messaging in the statement. They’ll want to emphasize 2019’s “patient” theme and that entails doubling down on the “data dependence”, although thanks to the shutdown, “data” itself has been lacking.

The December press conference was obviously a disaster, but Powell seems to have learned from that. His “performance” on January 4 in Atlanta (under the watchful eyes of Bernanke and Yellen, who were seated right next to him) was market-friendly, to say the least and is generally credited with engineering the YTD risk rally. He delivered an admirable encore in Washington on January 10, although he was momentarily tripped up by balance sheet questions.

Importantly, the December Fed minutes made it pretty clear that Powell’s communications skills were the problem last month, not the committee’s deliberations. That is, the dovish pivot was already well underway, he just didn’t “talk so good” (as it were).

Balance sheet questions are front and center and recent Fedspeak has indicated a willingness to tweak the pace of runoff under extremely adverse conditions, but as noted here on any number of occasions lately (see here and here, for instance), the market is looking for more flexibility than that. In other words, nobody wants to hear that it’ll take a recession to force a relent on “auto-pilot”. Last week’s WSJ trial balloon certainly suggests the committee is cognizant of that.

Let’s run through some quick sellside commentary (again) just to give everybody a frame of reference for the statement (some of this was in our week ahead preview, but it’s worth reprinting).

“Recent speeches by Fed officials have emphasized that the Committee can be patient for now and that decisions about further changes in the policy stance are data dependent”, Goldman writes, in their Fed preview, adding that they “expect both themes to be incorporated into the statement by noting that the Committee will ‘patiently continue to monitor incoming data.’” Here’s the bank’s mock January statement:

Goldman doesn’t expect any formal changes to the balance sheet plan, but notes that going forward, the market will be focused on the following two “potential changes”:

First, the FOMC could revise the June 2017 addendum to the Policy Normalization Principles and Plans, which currently says that “a material deterioration in the economic outlook” leading to “a sizable reduction” in the funds rate would be required to resume reinvestment before runoff has run its course. To us, even a scenario of limited rate cuts alongside continued balance sheet reduction–using the two tools simultaneously but at cross purposes–seems unlikely, and the FOMC might eventually lower the bar for ending runoff in the event of a slowdown in the economy.

Second, the FOMC could eventually taper its run-off by gradually reducing the monthly roll-off caps as the level of reserves approaches its longer-run level.

In their own preview, Barclays expects tweaks to soften the forward guidance in line with recent communications.

“We think the statement will say that ‘some further increase’ in the target range for the federal funds rate ‘may’ be appropriate to achieve the committee’s goals”, the bank says. On the balance sheet, Barclays notes that Powell “will likely need to address outcomes that would cause the Fed to slow or stop”. On the bank’s view, the presser will find Powell explaining that the committee “would be prepared to alter its balance sheet policies if a major deterioration in the outlook were at hand.”

Here are Barclays (two) mock statements:

(Barclays)

“The Fed will likely be challenged to deliver a sufficiently dovish message vs. market expectations, which risks a flatter rates curve and a risk off USD reaction”, BofAML writes, essentially reiterating the notion that the market is too “doved-up” (to quote Nomura’s Charlie McElligott. Here’s some additional color from BofAML:

In particular, we expect the Fed to remove the perceived calendar guidance of “further gradual increases” and replace it with more data-dependent language. We do not expect any formal announcements on the balance sheet, which risks disappointing some market participants. At a minimum, Chair Powell will likely reiterate his recent comments that the Fed is willing to be flexible with the balance sheet if it was seen as interfering with the normalization process or if economic conditions were to warrant an adjustment. He may also likely note the Committee has a preference for a large reserve-abundant framework, which the market currently expects. However, he will likely stop well short of signaling a near-term stop to the balance-sheet unwind.

Obviously, stocks plunged in the wake of the December meeting, helped along by Trump and his “greatest” shutdown. Here’s the S&P and the Russell with simple annotations for the December meeting and for the above-mentioned dovish relent in Atlanta.

(Bloomberg)

And here’s the same chart for the FANG+ index and the Nasdaq, just for fun.

(Bloomberg)

The dollar has come off and crude has rebounded, dragging breakevens along for the ride.

(Bloomberg)

High yield and IG spreads have come in 92 (!) and 22 bps, respectively in January after a Q4 during which the narrative was dominated by credit market concerns (spreads were sitting at post-2016 wides).

(Bloomberg)

So that’s where things stand. The fate of the rally generally hinges on whether the Fed can deliver a sufficiently dovish message to convince markets that a prospective renewal of the government shutdown (and the debt ceiling jitters that would accompany another impasse) and/or a negative outcome from the trade talks will be offset by vigilant, risk-supportive monetary policy.

Without further ado, they have removed the reference to further gradual rate increases. Not only that, the committee says it’s prepared to adjust balance sheet normalization.

They do reiterate (of course) that the target rate is the primary policy tool and describe economic activity as rising at a solid rate versus “strong” previously.

They’ve removed the mention of the risks to the outlook being “roughly balanced.” There’s no mention of the balance of risks. Instead, they note that in light of global economic and financial developments and “muted” inflation pressures, the committee will be “patient”

On inflation, they now say that market-based measures have moved lower in recent months.

This is all kinds of dovish on a first read.

Statement

Information received since the Federal Open Market Committee met in December indicates that the labor market has continued to strengthen and that economic activity has been rising at a solid rate. Job gains have been strong, on average, in recent months, and the unemployment rate has remained low. Household spending has continued to grow strongly, while growth of business fixed investment has moderated from its rapid pace earlier last year. On a 12-month basis, both overall inflation and inflation for items other than food and energy remain near 2 percent. Although market-based measures of inflation compensation have moved lower in recent months, survey-based measures of longer-term inflation expectations are little changed.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. In support of these goals, the Committee decided to maintain the target range for the federal funds rate at 2-1/4 to 2-1/2 percent. The Committee continues to view sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective as the most likely outcomes. In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

Voting for the FOMC monetary policy action were: Jerome H. Powell, Chairman; John C. Williams, Vice Chairman; Michelle W. Bowman; Lael Brainard; James Bullard; Richard H. Clarida; Charles L. Evans; Esther L. George; Randal K. Quarles; and Eric S. Rosengren.

Special Statement

After extensive deliberations and thorough review of experience to date, the Committee judges that it is appropriate at this time to provide additional information regarding its plans to implement monetary policy over the longer run. Additionally, the Committee is revising its earlier guidance regarding the conditions under which it could adjust the details of its balance sheet normalization program. Accordingly, all participants agreed to the following:

• The Committee intends to continue to implement monetary policy in a regime in which an ample supply of reserves ensures that control over the level of the federal funds rate and other short-term interest rates is exercised primarily through the setting of the Federal Reserve’s administered rates, and in which active management of the supply of reserves is not required.
• The Committee continues to view changes in the target range for the federal funds rate as its primary means of adjusting the stance of monetary policy. The Committee is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments. Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.

Implementation Note

The Federal Reserve has made the following decisions to implement the monetary policy stance announced by the Federal Open Market Committee in its statement on January 30, 2019:

• The Board of Governors of the Federal Reserve System voted unanimously to maintain the interest rate paid on required and excess reserve balances at 2.40 percent, effective January 31, 2019.
• As part of its policy decision, the Federal Open Market Committee voted to authorize and direct the Open Market Desk at the Federal Reserve Bank of New York, until instructed otherwise, to execute transactions in the System Open Market Account in accordance with the following domestic policy directive:
  

  “Effective January 31, 2019, the Federal Open Market Committee directs the Desk to undertake open market operations as necessary to maintain the federal funds rate in a target range of 2-1/4 to 2-1/2 percent, including overnight reverse repurchase operations (and reverse repurchase operations with maturities of more than one day when necessary to accommodate weekend, holiday, or similar trading conventions) at an offering rate of 2.25 percent, in amounts limited only by the value of Treasury securities held outright in the System Open Market Account that are available for such operations and by a per counterparty limit of $30 billion per day.

  The Committee directs the Desk to continue rolling over at auction the amount of principal payments from the Federal Reserve’s holdings of Treasury securities maturing during each calendar month that exceeds $30 billion, and to continue reinvesting in agency mortgage-backed securities the amount of principal payments from the Federal Reserve’s holdings of agency debt and agency mortgage-backed securities received during each calendar month that exceeds $20 billion. Small deviations from these amounts for operational reasons are acceptable.

  The Committee also directs the Desk to engage in dollar roll and coupon swap transactions as necessary to facilitate settlement of the Federal Reserve’s agency mortgage-backed securities transactions.”

• In a related action, the Board of Governors of the Federal Reserve System voted unanimously to approve the establishment of the primary credit rate at the existing level of 3.00 percent.

This information will be updated as appropriate to reflect decisions of the Federal Open Market Committee or the Board of Governors regarding details of the Federal Reserve’s operational tools and approach used to implement monetary policy.

Longer-Run Goals and Policy Strategy

FOMC_LongerRunGoals