Monday, October 6, 2014

One and Done?
Friday’s employment report was so good that the Fed’s doves should be hard pressed to put a bad spin on it. They’ve been doing just that to previous employment reports especially since Janet Yellen became the Fed chair on February 3 this year. She’s consistently focused on the weakest numbers in the monthly employment reports. The Fed’s doves want to hold off on raising rates for as long as possible. However, they’ve also said that monetary policy is data dependent.

With the unemployment rate down to 5.9% during September (the lowest since July 2008), the FOMC will be under lots of pressure to start raising the federal funds rate sooner rather than later in 2015. Here’s next year’s FOMC meeting schedule: January 27-28, March 17-18*, April 28-29, June 16-17*, July 28-29, September 16-17*, October 27-28, and December 15-16*. The ones with an asterisk will be followed by a press conference, which will give Yellen the opportunity to explain why the Fed decided to finally start raising interest rates. Given the strength in the labor market, I pick March 18 as D-Day.

Let’s recall what Fed Chair Ben Bernanke said last year at his June 19 press conference:
And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7.0 percent, with solid economic growth supporting further job gains, a substantial improvement from the 8.1 percent unemployment rate that prevailed when the Committee announced this program.
Well, here we are with QE scheduled to be terminated by the end of this month and the jobless rate under 6.0%. Regarding when the Fed will raise interest rates after QE is terminated, Bernanke said, “As I mentioned, the current level of the federal funds rate target is likely to remain appropriate for a considerable period after asset purchases are concluded.”

The phrase “considerable time” has been part of the boilerplate of the FOMC statements (in this post-QE context) since the December 12, 2012 statement, when the FOMC voted to morph QE3 (Fed buys $40bn/month in mortgage securities to infinity and beyond) was morphed into QE4 (Fed also buys $45bn/month in Treasuries) until the unemployment rate falls to 6.5%. It did so in April, falling from 6.7% to 6.3%. The strength of the latest employment report suggests that “considerable time” should be dropped from the next FOMC statement on October 29, especially since QE will be terminated by then. (See our searchable archive of FOMC statements.)

Of course, doves will always be doves. Consider the following:

(1) Yellen has a dashboard. Yellen can still find some weak labor market indicators on her “dashboard.” Most importantly, wage inflation remained at 2.0% y/y, well below her target of 3.0%-4.0%. The labor force participation rate fell to 62.7% during September, the lowest since February 1978. On the other hand, the short-term unemployment rate remains very low at 4.0%, while the long-term rate is down to only 1.9%, the lowest since February 2009.

(2) Evans advocates patience. Last Monday, FRB-Chicago President Charles Evans, who flies with the FOMC’s doves, told CNBC that he believes it would be "quite some time" before it's appropriate to start tightening. Evans sees June as a possibility for the first rate increase.

(3) Dudley is watching the dollar.On 9/24, Bloomberg’s Simon Kennedy reported that FRB-NY President William Dudley is the first Fed official starting to freak out about the strong dollar:

The risk is that Evans and Dudley are both correct. If the dollar continues to strengthen on expectations of a Fed rate hike, it could go to the moon on the first actual hike and threaten to slam the brakes on the economy just as the Fed is finally convinced that it has achieved escape velocity. If so, then that could be “one and done” for rate hikes.

Conceivably, it could also be “none and done.” When the FOMC finally votes to implement its exit strategy from ultra-easy monetary policy, they might find that the door is locked and no one has the key. In this scenario, stock prices could very well melt up.

I’m just thinking outside the box here. Other than last year’s taper tantrum in the financial markets, the Fed has succeeded in exiting QE. The Fed might succeed in normalizing monetary policy starting next year by raising the federal funds rate in a gradual fashion. What’s changed recently for the FOMC, and could complicate the committee’s exit strategy, is the strength in the dollar, which bears watching.
(Based on an excerpt from YRI Morning Briefing)

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