Via Stephen Stanley at Amherst Pierpont Securities:
Chair Yellen’s semi-annual monetary policy testimony is likely to be an important venue for the near-term outlook for Fed policy. The written testimony will probably be Yellen’s last scripted word before the March FOMC meeting, so if Yellen and the Committee perceive that a signal needs to be sent, this testimony will be the preferred vehicle for doing so. It seems worthwhile to briefly talk about what this appearance represents and what to look for.
The semi-annual monetary policy appearance by the Fed Chair is a legislatively-mandated exercise during which the Chair delivers the Fed’s Monetary Policy Report to the Congressional Committees charged with overseeing the Fed. The report is accompanied by hearings, which involve a submission of written testimony by the Chair as well as several hours of Q&A. The Chair’s responsibility in these appearances is to reflect the FOMC’s positions (as opposed to her own opinions).
So what can we expect this time around? The broad context for Fed policy is, as has been the case for years, the FOMC seems to be more hawkish than the markets. The fed funds futures contracts suggest that the market is pricing in roughly 2 quarter-point rate hikes this year (and a little less than 2 for 2018). Meanwhile, the last round of FOMC projections, released in December, showed that the median call on the Committee was for 3 quarter-point hikes. One key qualifier with respect to the monetary policy outlook is that there is heightened uncertainty regarding the conduct of fiscal policy. Eventually, the outcome in terms of taxes, spending, etc. will impact the economy and in turn the proper prescription for monetary policy, but for the moment, most officials seem inclined to wait and see what actually transpires before tweaking the monetary policy strategy.
Most of the market action this year has reflected the ebbs and flows of projected fiscal policy, the so-called “Trump trade.” For example, when tax reform looks more likely, interest rates tend to rise, and vice versa. That is perfectly logical, but at times, it feels like the markets are focusing so much on fiscal policy that the underlying economic situation gets ignored. The 3-hike scenario embedded in the “dots” did not really take into account additional stimulus from fiscal policy. Or to put it a different way, the strength of the economy, independent of any additional thrust caused by new tax and regulatory initiatives, is likely to justify a noticeable step-up in the pace of normalization relative to 2015 and 2016. As Fed officials across the hawk-dove spectrum have acknowledged, the economy is very close to, if not at, full employment, while inflation has moved much closer to the 2% target over the last 18 months.
While many will focus on what Chair Yellen says about the likely influence of fiscal policy on the Fed’s actions, I think this misses an important point. The pre-existent economy already necessitates substantial Fed policy normalization. As has been the case throughout this cycle, Chair Yellen and the other doves on the FOMC have been dragging their heels, but the case has gotten pretty compelling. In fact, a number of Fed officials, and not just the traditional hawks, have begun to agitate for hitting the dots forecast (of three moves this year) or more. Indeed, the tone has changed in a subtle way. The doves are still operating in the “I need to see a little more data” mode that has left the Fed and the market hanging on the latest data release, while the hawks and even some in the middle have begun to characterize the economy with a broader brush, arguing that the state of the economy dictates noticeably higher rates independent of the latest key data point.
In this context, Chair Yellen’s testimony falls at a very interesting time. The consensus view has been that rate hikes this year could be somewhat back-loaded. If the Fed goes three times, the most common forecast in terms of timing is June, September, and December. I have felt that the Fed would need to move 3 to 4 times this year, with the March meeting representing the swing factor. In other words, a key determinant of the Fed’s ultimate rate hike result for 2017 could be whether the Committee has the gumption (and the backing of the data) to pull the trigger in March, i.e. before the cloudy fiscal outlook will be resolved. In my view, the jury is still out on this question. A number of Fed Bank presidents have been agitating for a move sooner rather than later, but the most dovish members of the FOMC continue to express caution. The markets had all but priced out the possibility of a March move before Williams, Harker, and others told them explicitly that it should be considered “live.” The most important thing we will hear out of Yellen tomorrow in my view is whether her tone suggests that March is a) “in,” b) “out,” or c) possible. I expect her to choose option c. I doubt that she will try to explicitly jawbone the markets to expect a March move, but I also do not think she wants March to be priced out. Rather, she (and more importantly, the Committee as a whole) would presumably like to keep the Fed’s options open, especially with a full month’s worth of data due out before the FOMC meets again. At the same time, I will also be watching closely to see whether her description of the economy and the policy outlook seems to hang on the last data point or takes the broader view that more clearly justifies getting to a higher rate setting. In other words, will the Fed finally move from a first-difference orientation, always determining whether to move based on how much improvement has occurred since their last vote, or will they finally shift to a levels-based approach, seeking to find the proper rate level based on the broad contours of the economic situation?
The other key topic of conversation from a financial market perspective will be the Fed’s balance sheet. I have little doubt that this topic will come up at some point tomorrow, but it should matter a lot to market participants whether Yellen chooses to address it directly in her testimony or waits for a question to broach the subject. I expect the former. Given the fact that virtually every Fed official who has spoken this year has talked about it, I have to assume that the FOMC has discussed it, and I would anticipate that the Chair would want to report on that discussion, even if the guidance provided is very general. Indeed, I see balance sheet shrinkage as a story for the second half of this year (and I probably have one of the most aggressive Street forecasts on this parameter), so there is likely no great rush. At some point soon, I would really like guidance from Yellen on two key variables: 1) at what point in the rate cycle will balance sheet unwind likely begin (up to now, the view has been that something would happen once the funds rate gets to 1%, but as we get closer to that mark, a little more precision is in order) and 2) what is the plan for the first stages of the unwind? Presumably, the Fed will merely allow paper to roll off at first, but will it be Treasuries first, MBS first, or both at the same time? And how fast will roll-off be allowed early on? Will there be a slow “reverse taper” or a rapid transition? The more details she gets into tomorrow, the sooner we should assume balance sheet unwind is coming. For that reason, I would expect to see only a few vague generalities tomorrow, but the FOMC is going to have to figure this all out pretty soon if the balance sheet is going to be in play in 2017.