If I had to shoehorn the Fed’s communication yesterday into a single template, then I would use the following. The FOMC and Powell specifically highlighted a reaction function that is slightly more hawkish than expected, particularly as regards the next couple to few meetings. But their actual forecast and the logical apparatus behind it are benign and clearly dovish for the medium term. One might question if they are right. But on Fed days we learn what they think, not if they are right.
That template accommodates almost all of what was in the Press Release and Press Conference yesterday, although with an exception relating to the reaction function and with a separate exception relating to the logical apparatus. I will discuss those exceptions at the end of this note. But first, let’s fill in the template.
Hawkish short-term reaction function
The most obvious item relating to the hawkish short-term reaction function was the progressive near ruling out (barring a surprise in the data) of an ease at the March meeting. The Press Release introduced the idea that an ease would not be appropriate until they have further confidence that recent low inflation readings represent a trend. Then the Opening Statement concluded on the same theme. And in response to a question during Q&A, Powell was explicit that based on the information in hand today and the discussion at the meeting, the committee would not likely go in March. It would take a surprise.
The oddest signal of a hawkish reaction function was Powell’s repeated insistence on referencing the 12-month rate of core PCE inflation, inclusive of OER I might add. And at one point he made an aside suggesting the 12-month rate is the “target.” Either the Fed’s annual statement of objectives is wrong or – much more likely – Powell’s comment there is just flat wrong. But our day jobs are not to correct Powell on his reasoning, but to ask what the liberties he takes might be in service of. Misstating the Fed’s objectives in this way is obviously a hawkish signal. Simply swapping out the lagging government measure of average rents and swapping in marginal rents reduces the 12-month rate to 2.4%. But the more striking issue here is just the repeated insistence on the 12-month rate, which is wrong[1] and more striking for being so.
The other references to a hawkish reaction function can be distilled to bullet points:
· At one point, Powell seemed to be on his way to saying that they could “take advantage” of lower inflation to ease, but then corrected himself mid-sentence to say “be careful,” which makes a logically incoherent statement, again more striking for being so.
· Powell specifically rejected the signal from a Taylor Rule to ease.
· The Press Release retained the statement that they have a heightened sensitivity to inflation risk. That’s not new, but it slightly blunted the formal dropping of the “tightening bias,” for lack of a better shorthand.
One final point on the hawkish reaction function before moving on to the dovish forecast and apparatus. Powell struck me as passing the marshmallow test. He does not want to rush the satisfaction of declaring victory against inflation, even though his own forecast (with which I partially disagree) would rationalize that. Better to wait the extra meeting or two (as he sees it) to make the moment especially satisfying. In my humble opinion, some of this hesitation around what we might call an insurance ease is anchored in the (somewhat unhelpful) aversion to changes in the direction of the path of the funds rate that I have been emphasizing for a while now. But if we take that aversion as given, this might be roughly “second best” policy.
Dovish forecast and apparatus
That last point there might sound like a somewhat dovish take, but please keep in mind that I am contrasting the Fed’s reaction function with what I take to be their forecast. My own forecast is slightly more hawkish on a couple items, but it is not relevant when assessing Fed day. So let’s run down the ways the forecast and logical apparatus supporting it were revealed as dovish.
Powell was crystal clear that the base case for inflation is that it will continue to decline – on the 12-month basis he oddly emphasizes. He does not expect the shorter-run rates of growth to decline from here, but his central case is that they stay low, which will allow the 12-month rate to drift lower. He said he is confident in this take and that his confidence has been getting higher with time.
Separately, Powell repeats the line that policy is “well into restrictive territory” because the nominal funds rate less expected inflation is far above even the more hawkish estimates of the neutral real rate. In other words, he is sort of dissing the notion that broader financial conditions, which have eased, are the relevant metric here. And I will return to that in a second. But before leaving his own framework, I should add a related dovish aspect of it. He trotted out the textbook view that the policy restrictiveness, however, measured operates on the rate of change of the output gap, rather than on GDP growth itself. And he made explicitly clear a key implication of that: if the post-Covid recovery of the supply side were to slow, then aggregate demand growth itself would slow. I don’t think I need to elaborate further on that, but it might be worth pausing to internalize that this is a very dovish take.
Just as an aside on his dissing of financial conditions, that might seem like a pretty obvious flaw. The fact that financial conditions look easy does give the Fed the luxury to ease on their own schedule and not on the markets, as Paul McCulley helpfully pointed out ahead of the event during a CNBC segment. But this is not necessarily a logical contradiction on Powell’s behalf. One might argue that financial conditions are easy because the market believes the Fed will cut the funds rate. It is complicated in ways I have been over in earlier notes.
Powell also highlighted that nominal wage growth is slowing and that he expects that trend to continue. He referred to my own point that nominal wage growth remains too high, but he gave no quarter to my view that we ought not extrapolate the rate of change of wage growth, the so-called second derivative. No, even here, Powell is comfortable with second-derivative reasoning. That is consensus, but I would have thought his own take would be closer to my own there.
Exceptions
There were a couple items that do not fit into my template, but they reduce the shine, rather than wrecking it. In terms of the reaction function, we do need to recognize that they did drop the formal tightening bias, by restructuring the Press Release substantially for the first time in a while. The media had tried to get us jazzed that that would be the main news of the day. But the idea it would be was good for the first tick in 2s, I noticed. Then the very short end of the curve at least – and perhaps equities – went back to focusing on the fact that Powell is in no rush to ease.
The exception to the general dovishness of the forecast and apparatus relates a comment Powell made about goods price deflation. He expects it to abate, allowing goods price inflation to quicken towards zero. And given that, they will need to see further disinflation in services to prevent a reacceleration of the overall core PCE inflation rate. It’s a good point, one I have made myself. However, Powell’s actual forecast is that the short-term measures of inflation will stay low and that the 12-month rate will keep falling.
[1] The leadership had earlier implied that they would begin their easing program before inflation had fallen all the way to 2%.
