Two-track monetary policy

After making just three modest interest rate hikes since abandoning a seven-year stay near zero, the Federal Reserve can scarcely be accused of having a tight credit stance. As the rate-setting Federal Open Market Committee (FOMC) reiterated when it took the federal funds rate up 25 basis points in mid-March, “monetary policy remains accommodative.” 

But monetary accommodation, like beauty, is in the eye of the beholder, subject to market perceptions. Judging the degree of stimulus will get more complicated as Fed policymakers contemplate changing not just short-term rates but also their quantitative policy of putting downward pressure on long-term rates. 

After raising the funds rate target range to 50-75 basis points in December, few thought the FOMC would move again in March — until key officials signaled it would. Then, with Chair Janet Yellen warning against “waiting too long” and with hopes for stronger growth running high, rate hike expectations leaped. 

When the FOMC did move in March, markets interpreted its economic and rate projections and Yellen’s comments as dovish. The reaction was somewhat inexplicable to Fed officials, who saw their action as consistent with previously announced intentions; and it was. 

The FOMC did not elevate their economic forecasts or accelerate their rate hike projections; the median forecast was for 2.1% GDP growth this year and next, relative to a longer run 1.8% estimate, with unemployment falling to 4.5% and inflation rising to 2.0%. And as in their December dot plot, they foresaw three total hikes in 2017, with three more in 2018 and 2019 — leaving the funds rate at 3.0% — equivalent to the longer run “neutral” rate. 

There has been talk of the Fed raising rates more aggressively, and there is some sentiment for that among Federal Reserve Bank presidents. Chicago’s Charles Evans and Boston’s Eric Rosengren have talked of four hikes this year. But that’s more than the consensus.

Even three could be seen as acceleration, but only if viewed in isolation. Remember that at the start of 2015 and 2016, the FOMC anticipated four rate hikes, but ended up doing only one each year due to sluggish growth and geopolitical factors. It could be said the FOMC is just playing catch-up relative to those projections. In 2016, the dot plot projection was off by three quarter-point moves, so it wouldn’t be a stretch if they are off by just one (in the other direction) in 2017. 

With job gains averaging more than 200,000 per month, inflation approaching target, financial conditions supporting growth and risks “roughly balanced,” policymakers may get back on a steady, “gradual” rate path.

But the mood can hardly be called hawkish. Few officials are prepared to assume President Donald Trump will succeed in goosing growth. With weak productivity limiting potential growth, they can take their time. That could change based on growth and/or inflation, but for now, the Fed can afford a further tightening of the labor market without fear of undue wage pressures. 

The Fed, so far, has delayed shrinking its $4.5 trillion balance sheet. It has focused on getting that Fed funds rate away from zero to give itself room to cut if need be.
In March, the FOMC voted again to prevent any shrinkage by continuing to reinvest proceeds from maturing Treasury securities and principal payments from agency debt and mortgage-backed securities. And it reiterated it would keep reinvesting until rate hikes are “well underway.” 

But that one-track tightening approach is coming to an end. Even before the March meeting, there were rumblings of impending change. Fed Governor Lael Brainard, not usually considered a hawk, said balance sheet policy “may be approaching a transition.”The FOMC had an extensive discussion of when and how to curtail reinvestments and rollovers. Should they halt or taper, differentiate between MBS and Treasuries or tailor reinvestments to fluctuations in securities maturing. The Fed is sure to give itself flexibility. In some months, huge amounts will mature ($54.7 billion in Treasury notes and bonds in May 2018). To avoid yield spikes, the Fed could limit monthly runoff. 

Yellen defined “well underway” in terms of economic “confidence,” rather than any “particular cut-off level for the funds rate.” Not everyone is ready to start shrinking the balance sheet “now,” as St. Louis Fed President James Bullard advocates, but support is building to get started fairly soon. New York Fed President William Dudley says he  “wouldn’t be surprised” if the process begins “later this year,” and that reflects the FOMC majority, according to the March minutes.

Funds rate and quantitative policy are not separate and distinct. When it begins shrinking the balance sheet, potentially pushing up long-term rates, the Fed’s impulse to gradualism on short-term rates will be reinforced.