Fed grapples with immeasurables – TDS

The Fed reaction function in 2018 and beyond is fraught with uncertainty due to a number of factors, all of which are difficult to measure precisely, according to analysts at TDS.

Key Quotes

 “Composition of the FOMC: Even though the nomination of Jay Powell to chair the Fed suggests some continuity in the monetary policy framework, there are three more open spots at the Board (and another spot if Yellen leaves after her term as Chair is up). NY Fed President Dudley is also leaving in H2 2018. Such a large change in the composition of the Fed has the potential to change the direction of monetary policy. This is particularly the case in terms of regulation and the philosophical view on countering asset bubbles.” 

“Does inflation pick up (Phillips Curve)? Even though our macro strategists expect a pickup in inflation as some of the transitory factors such as wireless recede and labor market slack declines even more, it remains to be seen if the Fed’s 1.9% target for core PCE at the end of 2018 is achievable. The figure above highlights our forecast for inflation, which is a bit disappointing relative to the Fed’s target. Even though the unemployment rate at 4.1% is well through the Fed’s estimate of NAIRU, there is only evidence of a modest pickup in wage growth. Without more of a pickup in wage inflation, the Fed will find it difficult to continue hiking rates. There is research suggesting that demographic forces (older baby boomers being replaced by lower-wage millennials) may be behind weak wage inflation, but that trend should fade slowly.”

“Does r* show signs of pickup? One key assumption behind the Fed’s long run dot of 2.75% is the view that r* will rise over time. However, if we do not see signs of a sustained pickup in productivity or labor force participation, we think that the market will continue to expect the end of the Fed hiking cycle at a 0% real funds rate. This would be consistent with a terminal Fed funds rate of 1.75-2%.”

“At what point does demand for reserves show up? As the Fed allows its portfolio to run off, excess reserves in the banking system will shrink. At some point this could become a liquidity problem for banks, since the demand for excess reserves may resurface. Banks may want to keep some reserves at the Fed since reserves pay IOER (which is often higher yielding than short-dated Treasuries) or for LCR purposes. It is neither obvious nor easy to determine at what level of reserves the demand curve for reserves turns upward sloping. This can have implications for funding stress and the equilibrium level of the Fed balance sheet. Given that the Fed funds rate is trading well through IOER, we think that we are quite some time away from such funding stress.” 

“The market is pricing in 1.5 rate hikes next year while our macro strategists look for 2 hikes and the Fed’s median dot implies 3 hikes. Given the uncertainty about inflation and r*, we do not disagree all that much with market pricing. Significant deficit financed tax cuts could create upside risks to hikes next year.”