Ostensibly, the January Fed minutes should give the market some “fresh” (and that’s something of a misnomer here – it’s “fresh” to market participants, but it’s by definition three weeks old) color on the thinking behind what was variously described as a “capitulation” for the ages.
The FOMC’s “aggressively dovish pause” that found a previously recalcitrant Jerome Powell enshrining weeks worth of market-friendly rhetoric into official policy on January 30 set the stage for what has since morphed into an across-the-board “blink” from policymakers, who once again find themselves pondering how to reflate a global economy that’s losing steam amid gale force headwinds to growth and international trade.
Since the January meeting, consensus seems to be building around the idea that balance sheet runoff will cease by year end. It’s been trial balloon after trial balloon, soundbite after soundbite for three solid weeks now with regard to a prospective end date. In the meantime, markets are keen to know if the composition will be tweaked, with many analysts predicting a deliberate effort to shorten WAM in the interest of freeing up room for another Operation Twist later on down the road.
In the chart on the right above, Goldman attempts to show you the asset-purchase equivalent of a new twist based on an initial $3.5 trillion portfolio (the two bars on the left) and also the duration impact of a couple of different combinations of twisting and buying (the two bars on the right).
Traders and investors started obsessing over runoff in Q4 – you can thank Trump for that. While QT doubtlessly has a mechanical impact on risk assets, there is no accepted standard for quantifying that, and most efforts to estimate the rate hike equivalent of runoff so far, put it at ~1 (so, “one”) 25bps hike.
That said, SocGen reminds you that “if you add the current Fed rate of about 2.5% to the swift 300bp hike in the ‘shadow rate’ in the middle of 2014, reflecting the winding down of QE, the degree of tightening at present stands at about 5.5%, which is more elevated than the recent cycles.”
Whatever the mechanical impact on risk assets is, the psychological impact is clearly growing as the market becomes less and less comfortable with the contradiction inherent in tightening via QT and pausing rate hikes. This contradiction is even more glaring now that the January statement suggested the next move for rates could be a hike or a cut. Obviously, you cannot cut rates while proceeding apace with balance sheet shrinkage – that’s a contradiction that nobody will be willing to stomach.
As far as rates are concerned, the onus is now clearly on the data to justify further hikes and some argue that the Fed has now effectively adopted a single mandate focused on inflation. Multiple banks have downgraded their Fed calls over the past two weeks, with SocGen throwing in the towel on 2019 altogether.
Obviously, any overt references to an end date for runoff would be bullish for risk assets and any color around exactly what “patience” means would help market participants better assess the Fed’s new reaction function. Following the January meeting, Barclays fretted that the committee’s communications policy is now “in tatters”.
Without further ado, the minutes are out. Below are some lengthy bullet points followed by the full text. The key points around the “patient” characterization, the inflation outlook, the balance sheet and the market’s perception of the December press conference are in bold.
In case you’re entirely lazy and just want the two most critical points, they are arguably the following:
Almost all participants thought that it would be desirable to announce before too long a plan to stop reducing the Federal Reserve’s asset holdings later this year.
Many participants suggested that it was not yet clear what adjustments to the target range for the federal funds rate may be appropriate later this year; several of these participants argued that rate increases might prove necessary only if inflation outcomes were higher than in their baseline outlook.
Bullet point highlights
- December FOMC communications were reportedly perceived by market participants as not fully appreciating the implications of tighter financial conditions and softening global data over recent months for the U.S. economic outlook. Subsequent communications from FOMC participants were interpreted as suggesting that the FOMC would be patient in assessing the implications of recent economic and financial developments. The market-implied path for the federal funds rate in 2019 was little changed, on net, over the intermeeting period and investors continued to expect no change to the target range for the federal funds rate at the January FOMC meeting.
- In addition, some market reports suggested that investors perceived the FOMC to be insufficiently flexible in its approach to adjusting the path for the federal funds rate or the process for balance sheet normalization in light of those risks.
- Almost all participants thought that it would be desirable to announce before too long a plan to stop reducing the Federal Reserve’s asset holdings later this year. Such an announcement would provide more certainty about the process for completing the normalization of the size of the Federal Reserve’s balance sheet
- In particular, the level and variability of reserve demand and supply were likely to be much larger than in the period before the crisis, and stabilizing the policy rate in this environment would require large and frequent open market operations.
- The increase in volatility in financial markets in December was viewed as substantial and as likely exacerbated by thin year-end liquidity, among other factors.
- However, some other investors reportedly held firmly to the belief that the runoff of the Federal Reserve’s securities holdings was a factor putting significant downward pressure on risky asset prices, and the investment decisions of these investors, particularly in thin market conditions around the year-end, might have had an outsized effect on market prices for a time.
- Staff continued to monitor developments in the leveraged loan market given the sharp rise in spreads and slowdown in issuance late last year. The build-up in overall nonfinancial business debt to levels close to historical highs relative to GDP was viewed as a factor that could amplify adverse shocks to the business sector.
- Participants generally continued to expect the growth rate of real GDP in 2019 to step down somewhat from the pace seen over 2018 to a rate closer to their estimates of longer-run growth, with a few participants commenting that waning fiscal stimulus was expected to contribute to the step-down. Several participants commented that they had nudged down their outlooks for output growth since the December meeting, citing a softening in consumer or business sentiment, a reduction in the outlook for foreign economic growth, or the tightening in financial conditions that had occurred in recent months
- Participants commented on a number of risks associated with their outlook for economic activity, the labor market, and inflation over the medium term. Participants noted that some risks to the downside had increased, including the possibilities of a sharper-than-expected slowdown in global economic growth, particularly in China and Europe, a rapid waning of fiscal policy stimulus, or a further tightening of financial market conditions. An increase in some foreign and domestic government policy uncertainties, including those associated with Brexit, an escalation in international trade policy tensions, and the potential for additional extended federal government shutdowns were also cited as downside risks. A few participants expressed concern that longer-run inflation expectations may be lower than levels consistent with the Committee’s 2 percent inflation objective. Several participants judged that risks that could lead to higher-than-expected inflation had diminished relative to downside risks. The potential that various sources of uncertainty might abate more quickly than expected was mentioned as a potential upside risk for the economic outlook.
- Among those participants who commented on financial stability, a number expressed concerns about the elevated financial market volatility and the apparent decline in investors’ willingness to bear risk that occurred toward the end of last year. Although these conditions had eased somewhat in recent weeks, a couple of participants noted that the strain in financial markets might have persisted or spread if it had occurred during a period of less favorable macroeconomic conditions. A couple of participants highlighted the role that decreased liquidity at the end of the year appeared to play in exacerbating changes in financial market conditions. They emphasized the need to monitor financial market structures or practices that may contribute to strained liquidity conditions. A few participants highlighted the importance of ensuring that financial institutions were able to withstand adverse financial market events—for instance, by maintaining adequate levels of capital.
- Participants pointed to a variety of considerations that supported a patient approach to monetary policy at this juncture as an appropriate step in managing various risks and uncertainties in the outlook. With regard to the domestic economic picture, additional data would help policymakers gauge the trajectory of business and consumer sentiment, whether the recent softness in core and total inflation and inflation compensation would persist, and the effect of the tightening of financial conditions on aggregate demand. Information arriving in coming months could also shed light on the effects of the recent partial federal government shutdown on the U.S. economy and on the results of the budget negotiations occurring in the wake of the shutdown, including the possible implications for the path of fiscal policy. A patient approach would have the added benefit of giving policymakers an opportunity to judge the response of economic activity and inflation to the recent steps taken to normalize the stance of monetary policy. Furthermore, a patient posture would allow time for a clearer picture of the international trade policy situation and the state of the global economy to emerge and, in particular, could allow policymakers to reach a firmer judgment about the extent and persistence of the economic slowdown in Europe and China.
- Participants noted that maintaining the current target range for the federal funds rate for a time posed few risks at this point. The current level of the federal funds rate was at the lower end of the range of estimates of the neutral policy rate. Moreover, inflation pressures were muted, and asset valuations were less stretched than they had been a few months earlier. Many participants suggested that it was not yet clear what adjustments to the target range for the federal funds rate may be appropriate later this year; several of these participants argued that rate increases might prove necessary only if inflation outcomes were higher than in their baseline outlook.
- A few participants expressed concerns that in the current environment of increased uncertainty, the policy rate projections prepared as part of the Summary of Economic Projections (SEP) do not accurately convey the Committee’s policy outlook.