Monetary Policy & Inflation | US
As we head into the first FOMC meeting of 2020, and of the new decade, the Fed has a number of issues to deal with this year and thus everyone will be watching closely what they do. But now is not the time to make any major changes to policy. We expect the Fed wants this meeting to be a non-event and will reserve any new policy initiatives for later in the quarter.
First off, when it comes to the Fed’s economic and inflation outlook, we expect little change to the statement. Despite some data misses consumers are still in spending mode. The Fed will probably need to see how Q1 turns out before turning even more dovish, in our view.
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As we head into the first FOMC meeting of 2020, and of the new decade, the Fed has a number of issues to deal with this year and thus everyone will be watching closely what they do. But now is not the time to make any major changes to policy. We expect the Fed wants this meeting to be a non-event and will reserve any new policy initiatives for later in the quarter.
First off, when it comes to the Fed’s economic and inflation outlook, we expect little change to the statement. Despite some data misses consumers are still in spending mode. The Fed will probably need to see how Q1 turns out before turning even more dovish, in our view.
Second, although stocks have had a minor correction from the near-term highs, financial conditions are still easier now than they were in December. The challenge they face is how to wean markets off easy money while not committing to re-starting a rate cutting cycle, as priced by the markets.
Third, although there are a number of global developments (especially the nCoV virus) that present downside risks to the US, we doubt those will be mentioned directly. We expect reporters will ask Powell about the Fed’s stance vis-a-vis the developing coronavirus. We expect him to say they are monitoring the situation closely but that it’s too early to jump to any economic conclusions.
Reviewing FOMC Documents During Y2K (2000) and SARS (2003)
To gain some perspective of how the Fed may communicate policy going forward we searched FOMC statements and minutes during the beginning of 2000 and 2003, when the world was dealing with the Y2K conclusion and SARS.
It’s been a while since we last conducted such a review and it’s amazing to see how Fed communication has evolved. The first thing one notices is that back then there was less focus on markets and more on economic factors.
We found little written about Y2K in the reports we reviewed and nothing on SARS. With the Fed watching everything now, we don’t expect a repeat per-se, but we do not have any historical basis to go on when looking back to those two periods.
Scenarios: Monetary Policy on Hold as the Fed Waits for More Data
Note: We have dropped the hawkish scenario again as anything that sounds less dovish, even our base-case, could be viewed as partially hawkish. A market that is always expecting more liquidity will view a reduction or conclusion of Fed easing as a form of tightening, I know it sounds crazy, but that is what happens when you get markets hooked.
Base-case:
The Fed leaves interest rates unchanged for the second consecutive meeting, keeping the Fed Funds target range between 1.5 and 1.75%. There is some expectation that the Fed will raise the IOER rate up by 5 bps to 1.6%. We do not have a strong view on this tweak but given the current environment, even baby hikes would send a mixed signal. With the effective Fed Funds and repo trading at the bottom of the range (1.55%), it’s as if they squeezed in a cut, aided and abetted by the excess liquidity they have been injecting. So, it’s possible they try to nudge up rates.
After providing a safe passage for the repo markets over year-end, all eyes will be on what the Fed does with its so-called temporary open market operations (the repos) versus permanent balance-sheet growth (notQE). Powell will likely deliver a positive message that things in the money market are orderly now. Since they are still reviewing their framework and tools, it’s probably too soon to launch the SRF (standing repo facility). The Fed’s hope is that repo support phases out naturally (as it has since year-end) and that their TRM T-bill purchase program keeps re-stocking reserves in the banking system. Ultimately, we see the Fed launch a TRM 2.0 which will include them purchasing USTs out the curve to take pressure off bills.
Dovish-case:
The flight to safety rally in rates has driven many curves to the flattest levels (some have inverted) since last October. Meanwhile, money markets were recently pricing almost one and a half rate cuts for 2020. Having re-steepened the curve in 4Q19 to see it unwind may cause some anxiety for the Fed. If they are concerned about the shape of the curve, chair Powell can emphasize the hurdle to raise rates is higher than easing and they could also skip the IOER tweak. He could also state that the repo/notQE program conclusion has not been set. Suggesting liquidity remains open-ended would buy time to get to the March FOMC.
Market Implications:
At this meeting the Fed wants to keep all options open and not make alterations to its interest rate or balance-sheet policy. It’s quite possible that the Fed treats the adjustments to its Treasury reserve management and repos separately, even intra-meeting (both to show its not meant to be seen as a major initiative and also because they need more time). Or they could wait until the March FOMC to make changes (as they have basically penciled in these programs lasting until April). The tricky part is that all markets are so dependent on them keeping a dovish stance and liquidity flowing. If conditions worsen in Q1 those expectations will only intensify as markets would expect the Fed to save the day again.
Rates are signaling the Fed is committing a policy error again and stocks are looking at the rate levels and feeling confident the Fed will ease. This is a very tenuous state of affairs for all risk takers and highly circular. For now, the only curves that can stay steep are beyond the 10yr sector. But if global factors, like the nCoV virus intensify, the curves will keep flattening.
Net net, this meeting will be the first test of many, to see if they view their insurance easing as being enough to sustain the economy, and if not, how preemptive will this Fed be at easing further with no real evidence for it.
George is a twenty years fixed income markets veteran. Over that time he has covered rates, structured products and credit. He worked both on the buy-side and sell-side.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)