By John Authers March 21, 2018
Jay Powell has undergone his first ordeal as chair of the Federal Reserve’s Federal Open Market Committee, and he has been rewarded with a counterintuitive sell-off in the dollar. When the FOMC’s announcement came out, and then as he gave his press conference, the dollar fell:
The forex market saw a notably dovish Fed, evidently. Meanwhile, the stock market (which wobbled but ended down very slightly), and the bond market (which ended with the 10-year Treasury yield still just below 2.9 per cent) reacted as though little, if anything, had changed.
Why would this be? The best argument in favour of reading this as a dovish Fed comes, I think, from this chart in the FOMC’s package of projections and materials.
This represents the Fed’s best guess on where the PCE, its favoured measure of inflation, is heading. Basically, it appears to have no concern whatever. As it is “symmetrical” in its approach to its 2 per cent target, equally happy to be above as below it, it would appear that not a single Fed governor seriously fears that inflation is going to take off. After several months in which the fear of resurgent inflation for the first time in a generation has dominated chatter on markets, this does seem strikingly relaxed.
The other critical point in favour of reading the Fed as doves is that the median projection for interest rates this year remained unchanged. We should brace for two more rate rises of 25bp after this one. The crucial numbers appear in the bottom two lines:
If people are really putting this much weight on the “dot plot” in which Fed governors give their best guesses for future rates, it marks a radical departure. For years after the crisis, the Fed has published dot plots projecting imminent rate rises, the market has flatly refused to believe them, and the market has been proved right. Now the dot plot appears to be taken as a key reason to believe in dovishness.
If this is so, I believe it is wrong. The unchanged median looks to me like a statistical quirk. In the following chart, you see December’s dots for 2018 and 2020 ringed in black, and the latest dots for those years ringed in red:
The median may remain unchanged, but the FOMC members, as a whole, have unmistakably grown much more hawkish since their last meeting. The tax cut legislation, and the rise in bond yields since then might explain this. Otherwise, inflation has remained supine, while unemployment has continued with its well established trends.
Why then has the market responded in the way that it has. In my own attempt at an Instant Insight for the Financial Times, I offered two explanations for why the Fed might be as confident on inflation as it appears to be:
There are two potential explanations. One is that the Fed collectively believes that the “Phillips Curve” trade-off between inflation and unemployment is over. Employment can rise without pushing up inflation.
The other is that it has confidence that it can contain inflation by raising interest rates.
Markets appear to be placing their bets on the first explanation.
There are, however, two other intriguing takes on why the market has behaved the way it has. One is that in fact the Fed has signalled a far more dovish approach, by signalling a willingness to allow inflation to go above 2 per cent. This is the explanation of Steven Englander, once head of FX analysis for Citi and now at Rafiki Capital:
there was a huge element of dovishness in the projections that has been missed in the commentary — if you are a central bank that expects to overshoot its target with six hikes over the next two years, you can always go to seven or eight or ten if that’s what it takes to land smack on 2.0% in expected value terms. So if you see a couple of 2.1%’s on inflation and decide you can deal with it slowly over a couple of years well beyond your forecast horizon, you are implicitly endorsing an overshoot. Compare and contrast with the ECB that always has just under 2% at the end of the forecast, because that is what they see as their job.
It is not magic to say that if you really want to land at 2%, just tighten faster. The Fed has the UR well below the NAIRU so the employment and inflation above its target, so it there is nothing to stop them from tightening a bit faster, except if implicitly they see above 2% inflation as catch-up …
You can talk all you want about these being long-term projections but that is not the point. If the central tendency is above 2% for two years it means that the typical FOMC participant is not worried about a temporary overshoot. That tells you something about their reaction function in 2018 as well as 2020.
This is very dovish and asset markets have not yet reacted fully to the dovishness, although the FX market has caught on to some degree.
The key question here is whether it is really that dovish to regard 2.1 per cent for a year or two as an “overshoot”. I may be wrong here, but I thought 2 per cent was a central target and that the Fed was symmetrical in its approach to it; an overshoot would be no worse than an undershoot, and a 2.1 per cent rate would suggest that it had done a better job than a 1.5 per cent rate had done. It did not strike me that Mr Powell was giving that much away by calmly projecting 2.1 per cent inflation for two years — it almost implies confidence about the strength of the economy.
Against this, 1) Steven Englander knows vastly more about the FOMC and the FX market than I do and 2) his theory does have the virtue of explaining what has happened.
A second explanation was offered to my colleague Alex Scaggs by Robert Tipp of Prudential:
The fear is of the Fed breaking the system and creating a risk correction. If the Fed is espousing a very bullish view, and you’re getting a decline in real yields and a weakening of the dollar, and weaker equity prices, you have to ask yourself, is that really a ringing endorsement?”
When you look at the statement, they acknowledge the data slowed down. But in their projections they boost their rate trajectory and they boost their inflation outcome,” he said. “This environment probably does not require aggressive monetary policy.”
Ultimately it’s difficult to read too much into one set of market reactions, but the confident tone of the Fed and the confident set of projections has the market on edge and could backfire.
One of the most vivid times we saw this was in 1987 — and the Fed was hiking interest rates and markets were very buoyant and eventually the deficit was very large, so it was very highly reliant on foreigners underwriting the deficit, the dollar was weakening, and you had a correction in the stock market due to technical factors, but ultimately the genesis for that was fear of a weaker dollar and reliance on foreign capital.
You have an uncomfortable trade situation, the Fed hiking rates, the dollar falling from an elevated level, and today in the flight to quality, you’re seeing a rise not just in the yen, but the euro more than the yen.
On this analysis, Jay Powell is not guilty of dovishness so much as hubris. The market thinks the Fed is being wildly overconfident (some others are also criticising the Fed projections for not taking possible tariffs into account). The markets think that the newbie is overconfident, not up to his new job, and riding for a fall.
Certainly the growth and employment projections look very rosy. It would also make sense for FX to be the market that is most worried, as foreigners are prone to perceive overconfidence in Americans.
But again, I am not sure that I buy this. The dot plot ultimately implies a significantly more hawkish Fed, which expects to double rates from where they are now, and which expects to have to work to douse down the effects of the fiscal stimulus that has just been administered. The strong projections add to the likelihood that it will follow through with rate rises.
One final possibility, laid out by JPMorgan’s Marko Kolanovic, blames the weather. It is snowing and horrible in New York today. I am writing this in my bedroom, trying to fight off children who are spending the day at home because schools are closed. Many Wall Street traders are putting up with the same conditions. This is Marko’s take:
Fears of the Fed delivering a hawkish message did not materialize. 2018 dots were not revised higher, and the importance of the 2019/2020 dots was downplayed by Powell (realistically, no one can have visibility 2 years out). Bond yields went lower, USD weakened, and the yield curve steepened — all of which are positive (dovish) signals for US equities. Furthermore, there was no significant change in inflation expectations and the growth outlook, alleviating recent equity markets concerns. This outcome is a positive and indicates that equity investors could expect a near term goldilocks environment. In contrast to the Fed, price action of the S&P 500 was not coherent — first we saw a strong rally and reversal, then another (smaller) rally and reversal, with the market ending slightly down. We note that this happened on very low volumes (particularly in light of the importance and anticipation of the catalyst). This was likely the result of a severe snowstorm affecting the US northeast and incomplete market participation (e.g. it was one of the lowest futures contract volumes on any Fed announcement days). Market direction was further confused by the initial reaction of bonds and rotation out of tech and momentum stocks, inflows into small cap, value and high volatility stocks, and covering of high short interest stocks.
So my best guess remains that Mr Powell tried to send a more hawkish message than the market received. Higher stock and bond prices keep the economy chuntering along nicely for now, as does a weaker dollar, but there are dangers for the future.
The issue of trade, on which it appears we may well know far more by the end of the week, has the potential to throw the spanner into a lot of works. On the face of it, aggressive tariffs could raise inflation while reducing growth over the next few years. That said, as the area is still utterly fraught with uncertainty, it seems to be totally responsible for Mr Powell and his colleagues to have decided not to incorporate any assumptions on trade into their forecasts.
This take from Jim O’Sullivan of High Frequency Economics is worth reading:
In the short term
The stock market sell-off at the end of the day robbed Mr Powell of what was setting up to be the best stock market debut for a Fed chairman since William “Punch Bowl” Martin started the job in 1951. Generally, as this chart shows, the stock market is disconcerted when a new chairman presides over the FOMC for the first time. And Mr Powell may be relieved to be no different.
Also note that since Martin, the only positive stock market welcome went to Paul Volcker, who would soon after force the stock and bond markets into historic bear market bottoms. So there is no need to take short-term stock market judgments too seriously: