3 Fresh Perspectives On The FOMC

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by: Curve Advisor

Summary

Interest rate policy is now the Fed’s secondary policy tool. It will first increase the balance sheet taper at every quarterly meeting.

The Fed’s three top economists will have left by mid-2018. This may result in a higher reliance on Fed staff economists.

Multi-level thinking would imply that the bar for the Fed to invert the yield curve is high.

The US Federal Reserve raised its policy interest rate 25 basis points this week and increased the pace of its balance sheet reinvestment tapering from $10 billion to $20 billion. Despite all the activity that is going on, most analysts would consider this a relatively "ho-hum" meeting. The markets agreed, based on the declining interest rate volatility going in. Amid this complacency, I thought I would give you three fresh perspectives on FOMC dynamics going forward, not including the very obvious changes at the Fed Chair and new Board members that need to be selected.

1. Interest rate policy is now the Fed's secondary policy tool. Contrary to Fed member statements, interest rate policy is not the primary policy tool. When the FOMC sit down for the next 10 months to deliberate on interest rate policy, the first thing they will all know is that they just increased the tapering of its balance sheet (at every quarterly meeting). They are on a preset course to increase tapering, and thus they will have tightened monetary policy before any decisions on interest rate policy have occurred. This, on the margin, could slightly raise the bar on future hikes in the next year. After all, knowing that they increased tapering means they are being "active" in tightening monetary conditions, even if no rate change occurs.

2. The Fed's three top economists will have left by mid-2018. Yellen, Fischer, and Dudley will have all departed. This leaves a massive economics hole in the FOMC. The trend with Federal Reserve Bank selections in recent years has been from the business (non-economics) sector: Harker (Philadelphia), Kashkari (Minneapolis), Kaplan (Dallas), and Mullinix (interim - Richmond) are all from the business sector. The only economist to be named Bank President the past three years is Bostic (Atlanta). It is unclear who Trump will select to the Board of Governors, but I'm not so sure a business person is going to overwhelmingly select economists. So far, Trump is one and one - Quarles is a businessperson, and Goodfriend is an economist. The FOMC could be more reliant than in the past on the Fed's staff economists for their analyses. The staff economists have seemed slightly more dovish than the FOMC members in the past 12 months. The staff economists saw balanced risks to both growth and inflation at the last several meetings. However, at both the December 2017 and March 2018 meetings, the staff economists saw on balance, downside risks to growth. The Fed ended up hiking at both of those meetings. It is possible a Powell-led FOMC will be inclined to weigh the opinions of the staff economists more, since there is a lack of economists on the FOMC.

3. Multi-level thinking would imply that the bar for the Fed to invert the yield curve is high. Analysts calling for an inversion of the yield curve are "first level" thinkers. That is, they think about the facts at hand - a strong economy that theoretically should have higher shorter term rates and a global QE drag on longer term rates. They do not adequately factor in how the various players will adjust in reaction to the current environment on the "second level." For example, Bullard, Harker, and Kaplan have all implied that they would be reluctant to hike if that would invert the yield curve. An inverted yield curve is taboo, as history suggests that is a signal of an impending recession. History may or may not apply in the current environment of global quantitative easing. But we know for a fact that some members of the FOMC may be cautious of overly flat yield curves. This makes aggressive hikes that much less likely in a game theory context. This is not to say the Fed couldn't aggressively hike if the conditions warrant. It just seems less likely that the US would be that much different than Japan, Europe, or any of the other developed economies that have been experiencing prolonged low inflation and wages for years (or even decades). At some point, the yield pick-up on the front of the yield curve between the US and EU/Japan could be so attractive that we could see a rotation from global long end buying to the shorter end. This may also reduce the odds of a yield curve inversion.

It seems like most economists and analysts that appear on television interviews call for three or four hikes next year. This is not dissimilar to the Fed's dot plots. The Fed may not be using "second level" thinking in their dot plots either. The three factors above could add to less Fed action than the current Fed narratives or dots imply. This may be one of the reasons the markets have consistently underpriced the number of Fed hikes. However, we are data-dependent, so let's see what the data has in store for us.

One of my New Year's resolutions will be to post more on Seeking Alpha next year. Let me know if there is something related to short-term interest rate futures trading you would like to see. Happy Holidays.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.