Central bankers are set to hike interest rates at this week’s meeting of the Federal Open Market Committee (FOMC), an outcome widely expected by market participants and thus should come as no surprise. The economic projections will probably look a little stronger relative to January. I don’t anticipate large changes to the interest rate projections for 2019 and 2020; the general story that the Fed expects rates to rise above neutral will still hold. The 2018 median projection will likely rise to reflect a full four rate hikes this year (that only takes the shift of a single dot).
Attention will fall heavily on changes in the accompanying policy statement given expectations that the Fed will try to reduce market reliance on forward guidance in the statement and at least by default raise the importance of the forecasts. This shift risks creating more uncertainty about policy than the Fed intends because unlike the statement, the forecasts do not represent a consensus view of policy. Be prepared for more noise as policymakers may more often stake out public positions that appear at odds with those of key policymakers. To navigate the noise, focus additional attention on the statements of permanent FOMC voting members.
The minutes of the May FOMC meeting first hinted of a change in the statement the Fed issues to explain its policy decisions. The descriptions of the policy rate as “accommodative” and “likely to remain, for some time, below levels that are expected to prevail in the longer run” will soon be no longer valid. With just two more rate hikes, in June and likely September, policy rates will be at the low end of the estimate range of neutral policy. This near-term path of policy is thus at odds with the current language.
Moreover, as I explained here, the Fed will turn off the autopilot – the expectations of gradual, once a quarter, 25 basis point hikes – by the end of this year. Once policy rates are in the neutral range, central bankers recognize policy will be increasingly dependent on the expected path of the economy. It is thus more difficult to make promises of future policy.
Any headlines that interpret the changes as an end to forward guidance would be overstatements. The Fed will be changing the language of the statement to match reality. They won’t be abandoning forward guidance entirely. For example, they will retain the “dot plot” of monetary policy expectations. This means that while central bankers reduce the forward guidance provided in the statement, they will by either default or intention increase the importance of the forward guidance provided by the Summary of Economic Projections (SEP). The SEP informs on the Fed’s reaction function, or how its policy approach will change in response to evolving economic data. Via Reuters, here is incoming New York Federal Reserve President John Williams on the communication shift:
“…I think we just need to frame that where the economy is and how we are thinking about policy going forward a little bit differently. And when I say a little bit differently I mean less forward guidance in the language, less language about where we see policy moving, not necessarily no language about it, but less language about it. And more, I think, just trying to express as effectively as possible our views on the economic outlook, how policy fits into that economic outlook, and then use the quarterly economic projections, along with obviously the dot plots, to help put some numbers and some facts and figures that kind of fit in with those statements….
What we should be explaining to people as much as we can is our reaction function, helping people to understand how monetary policy responds to the changing economic outlook in the context of our dual mandate goals. Trying to put that into words… sometimes just is hard to do and not that effective.”
This shift in emphasis will increase the uncertainty surrounding the path of future rate hikes. Partly this is a feature, not a bug. It simply reflects the reality that policymakers will be less sure of the path of rates after reaching a neutral policy stance. The risk for financial market participants is that this shift in emphasis raises uncertainty not only from the economic outlook but also from the “cacophony of voices” problem as policymakers take public positions on the path of rates that appear at odds with each other.
The problem of relying more heavily on the SEP is that unlike the statement, the economic projections do not represent the consensus of central bankers. Each policy maker provides an independent forecast. We have become accustomed to using the median of the SEP forecasts as a proxy for the consensus view of the FOMC, but this is not accurate as no such consensus view exists.
I suspect we are going to see policymakers attempt to both raise the importance of the forecasts as Williams does above while at the same time downplaying the relevance of the dots. That’s a recipe for policy confusion. More look at this, but don’t really look at this. In addition, policymakers will further aggravate the confusion because they also find the median forecasts useful as a baseline. For example, see Federal Reserve Governor Lael Brainard here.
Bottom Line: The Fed is set to hike rates this week and change the communication strategy. To navigate this change, first recognize that altering the current forward guidance in the statement does not mean the Fed is shifting to a more hawkish stance as it by itself shouldn’t impact the expected path of rates. Any shift in the path of rates will be driven by the data. It will increase the uncertainty of the timing of future policy changes. Assessing the path of policy will become more difficult especially because the Fed lacks an official consensus outlook for the economy and interest rates. Beware the cacophony of Fed speak. There will be a risk of confirmation bias as it will be easy to find a policymaker whose views conform to your own. Instead, watch carefully how incoming data is shaping the opinions of permanent FOMC voting members as they are people that will be driving policy outcomes.