FOMC Meeting May Set Stage For Next Phase In Interest Rate Normalization

Washington (Oct 28)  The Federal Open Market Committee meets Tuesday and Wednesday, and financial and commodity market participants will watch to see what policy-makers may say about the next step toward normalizing interest rates.

Most economists expect the Fed will end its quantitative easing program at this meeting, something that has been telegraphed for several months now. What will be more important, sources said, is what the Fed may say about future monetary policy, also known as forward guidance.

Millan L. Mulraine, deputy head, U.S. research and strategy at TD Securities, said the Fed needs to balance how they prepare for any policy tightening next year, but also avoid been seen as “divorced” from the rest of the world that is concerned about falling economic growth. That could mean a more dovish Fed meeting, he said.
 “With domestic growth momentum beginning to leak lower and the medium-term outlook for the recovery and inflation becoming less certain, we expect the statement to be tweaked sufficiently to reflect a more dovish bias towards the near-term monetary policy stance,” Mulraine said.

A more dovish-sounding Fed may give some support to gold prices, traders said, especially if there is a sense that interest rate hikes in 2015 may be pushed back.

Dorothy Weaver, co-founder and chief executive officer of Collins Capital, and former chairman of the board of the Atlanta Fed’s Miami branch, said the Fed is keeping an eye on the markets, especially in light of some of the turmoil seen earlier this month when commodity and stock markets fell and U.S. Treasury yields sank on concerns about the global economy.

 “Clearly last week was very keenly observed by the Fed,” Weaver said. “Clearly the Fed has had volatility on a morphine drip. And we had volatility at historically low levels. Last week, we had a hint it (markets) might be coming off the morphine drip. We saw volatility turn, had the market get very skittish, and saw dramatic reaction of the 10-year (yield) dropping so quickly.”

While supporting financial markets is not part of the Fed’s mandate, it “is important to them in trying to gracefully get through this inflection point,” she said.

The Road From Here

Zachary Karabell, head of global strategy at Envestnet, said the Fed’s issue now is a balancing act.

“Now their issue is more what should the right level of rates be relative to economic activity. I think the challenge is that, from my reading, is there are some hawkish members, and then there’s the general committee take, which is no rush to raise rates. There’s a clear determination to the end QE, but I think there’s been a consistent drumbeat that the markets have either ignored or discounted which has been there is a big gap … and should be between the end of QE and the raising of rates,” Karabell said.

Mulraine said as the Fed seeks to put some distance between ending the asset-purchase program and normalize policy, it is facing some obstacles.

“The communication challenge facing the Fed in calibrating its message has become more complicated in recent weeks. Indeed, even with significant progress in both the labor market and the economic recovery in recent years, the combination of weakening global growth momentum and a stronger dollar has injected sufficient uncertainty into the medium-term U.S. economic outlook to warrant caution. Add to this mix the weakening inflationary momentum and stagnating wages, and the case for staying the course is gaining ground,” he said.
The Fed, Karabell and Weaver said, is looking to broaden the number of data sets it uses to take the temperature of the economy, rather than relying one end point. In the past, former Chairman Ben Bernanke had given an unemployment target of 6% as a threshold to raise interest rates. With Chair Janet Yellen, that’s changed.

“We’ve gotten the sense for a quite a while to (not) hang your hat on any given number. Even though she continues to say (Fed policy is) data-driven, she wants to keep (open options) and her ability to respond to what she feels is the current situation and not let some trip wire force her hand,” Weaver said.

Although the unemployment rate recently dropped to 5.9%, it no longer is the Fed’s threshold, Weaver said.

“The devil’s in the details. How did it get there? It didn’t get there because an overwhelming number of jobs were created. It got there because of the lack of participation climbed. Yes, it gets you there, you can declare victory and go home, but it doesn’t solve the problem of taking warm bodies and putting them in meaningful work,” she said.

Karabell said the Fed using more data sets to guide monetary policy is a good thing, even if it’s not universally welcomed.

“The data-dependent thing, everyone pooh-poohs. It’s real and it should be real. The idea that you should have a plan in place that’s specific to raise rates would suggest that you begin to ignore what’s actually going on,” he said.

What that means, Karabell said, is the Fed is responding to “the world as it’s evolves and not the world as we think it should, which means maybe they’ll rates in the middle of 2015, and maybe they won’t.”

Mulraine said given the recent weaker inflation readings, there is a chance the Fed may adjust its risk assessment on the growth and/or inflation outlook. The Fed may highlight potential downside risks to the underlying strength in the broader economy because of the weaker global economy and stronger dollar.

“Similarly, the inflation risk assessment could also be revised to reflect the softening in both realized and expected inflation. As with the growth assessment, the September minutes indicated that ‘several members’ have become concerned that ‘inflation might persist below the committee's objective for quite some time.’ We assign a high probability to this inflation reference being reworked. “

Wage inflation is the No. 1 inflation reading concerning the Fed, Weaver said.

“On one hand they want to see improvement in wages because they’ve been flat for so long. On the other hand they have to worry about what they wish for. Once (wage inflation) start(s), it’s a four- to five-year cycle. It’s not something you can turn on and off,” Weaver said.

The Fed has to weigh how much the structural unemployment, that is workers out of a job for longer than six months, the mismatch of open jobs and skilled employees, and workers who have dropped out of the job market but may come back, could change the labor picture if the economy improves, she said.

“Could we be nearer to a tipping point than the Fed is currently thinking? (The Fed is still focused on) data, data, data. But that’s not hard data because it’s a lot of human behavior and that’s going to be tougher,” Weaver said.

Source: KitcoNews