Stephen Miller on the Fed, the RBA and the BoE

From

Stephen Miller

FOMC announces taper

  • Fed Chair “patient” on policy rate increase but will act if necessary.
  • Inflation still “largely” seen as transitory but the FOMC Statement indicates less certainty on that.

As was widely anticipated the Federal Reserve’s FOMC announced that the Fed would begin winding down its monthly bond purchases at a pace of $15 billion per month, reducing Treasury purchases by $10 billion and mortgage-backed securities by $5 billion. At this stage, the FOMC expects to keep winding down purchases so that the taper process would be completed by June 2022, although it noted that changes in the outlook might occasion an adjustment to those plans.

The Fed also noted that inflation remains elevated and continued to suggest that inflation would be “largely” transitory, although the Statement indicated a little less certainty that the jump in inflation would be as short-lived as previously thought. The Statement rephrased the inflation picture portraying elevated inflation, reflecting factors that are “expected to be” transitory. The previous statement was more definite that elevated inflation was “largely reflecting transitory factors”. This was a signal of less confidence in the inflation outlook, conceding that high inflation might be prolonged. In his press conference Chair Powell admitted that the Fed took a “step back” from transitory at the September meeting. The median projection of the Fed’s preferred core PCE measure of inflation was upwardly revised again for 2021 to 3.7% (from 3.0% in June and 2.2% in March). Although it does have inflation returning to longer-run targets of close to 2% in subsequent years. In the press conference, Fed Chair Jerome Powell said that inflation pressures may wind down by the second or third quarters of next year. Recent high-frequency price indicators from both the manufacturing and non-manufacturing ISM reports indicate that price pressures remain at multi-decade highs.

The taper announcement opens up the possibility that the Fed may raise the policy rate in the second half of 2022, with nine of 18 officials forecasting a move next year in their September outlook. Chairman Powell said that tapering “does not imply any direct signal regarding our interest rate policy” and that the central bank “can be patient” when it comes to rate-hike timing but added that “if a response is called for, we will not hesitate.”

US 10 year bond yields rose on the news and stocks were up on the day. That reaction was a long way short of the “tantrum” on the scale of then Fed Chair Bernanke’s announcement back in the May 2013. The key difference this time around is that such a move had been well-telegraphed by the Fed Chairman in contrast to the “drive-by” announcement from then Fed Chair Bernanke back in May 2013.

RBA stuck on the “emergency” setting

  • RBA communication insufficiently nuanced.
  • RBA SoMP released Friday.

In announcing what were  – at least compared to market expectations – a marginal ‘tweak’ in what it had described as “emergency” policy settings, the RBA seemed determined to consolidate its new-found reputation as the ‘uber-dove’ of developed country central banks.

In so doing, the RBA acknowledged that it had underestimated inflation but forecast revisions are arguably modest. Perhaps more interestingly, according to John Kehoe in the AFR, the Governor appears to believe that the persistence in inflation seen everywhere else in the developed world is not as meaningful in Australia. As Sir Humphrey Appleby might say, that is a “courageous” stance. The Governor appears to point to key differences in the underlying structure of the Australian economy compared with other developed countries.  These include the labour market and the pervasiveness or otherwise of the “Great Resignation” phenomenon, fossil fuel dependency and pastutility price restraint, or even the starting point for wages growth. But such a stance is backward-looking and therefore of marginal importance. Australia is subject to the same laws of economics as other developed nations. The Governor is locked in a firm embrace of the “transitory” inflation rhetoric that other central bank chiefs trotted out in the first half of this year. Now those same central bank chiefs are disengaging from that “transitory” rhetoric because it is either not accurate or not helpful, or both.

By and large, the RBA has done a very good job in mitigating the economic dislocation wrought by the pandemic. It acted expeditiously and with considerable skill through 2020 in instituting “emergency” measures. But the “emergency” is past. The unemployment rate is below pre-pandemic levels. Inflation is emerging. Nascent financial stability concerns are growing. Wealth inequality (through rapid real estate inflation) is growing.

In this context, a bit more of a ‘tweak’ may have been considered. Just as relevant might be the nature of the RBA communication. Even an acknowledgement that the “emergency” is past.

Insufficiently nuanced communication

Part of the confusion evident in markets around the RBA meeting lies in the manner of RBA communication. In short the convulsions in the bond market are compounded by an insufficiently nuanced communication strategy that failed to emphasise the inherent uncertainties attaching to the economic outlook and attendant monetary settings.

The Governor’s Statement and press conference didn’t help.  In his prepared remarks in the press conference the Governor stated that our “forward guidance is based on the state of the economy, not the calendar” but his Statement and press conference were littered with calendar references. And, as noted above, explanations as to why inflation is different (lower) in Australia are unconvincing. In his Statement the Governor noted that “bond yields have increased recently and bond market volatility has also risen significantly.” Tuesday’s Statement and press conference did little to assuage concerns of volatility going forward.

In fairness, perhaps even in the wake of a welter of evidence to the contrary, the RBA assumes markets possess an interpretative capability way beyond that which exists.

That being the case, the RBA needs to work on communication. Perhaps focussing on quality of communication rather than quantity. In particular it might explain uncertainties in the outlook and the distribution of risks around central scenarios and their attendant implications for policy. Rather than references to calendars the Governor might have said:

  • The RBA has an outcomes based forward guidance (OBFG) that is based on the state of the economy.
  • These are our forecasts but uncertainties abound and the distribution around them are wide (or skewed to the upside?).
  • If our forecasts are met in an accelerated fashion we policy will respond accordingly.

Tactical versus strategic

Tuesdays announcements were tactical.

However, perhaps the time has come to review that framework in a more strategic way.

In this context much is made of a move to ‘outcomes based forward guidance’ (OBFG). In essence, OBFG means that rather than be satisfied with a forecast that inflation will rise above a target (2-3 per cent in the RBA’s case), the central bank will await an outcome that they believe indicates persistent inflation above that target. Nor does the ‘outcome’ need to be inflation-based: it can be multi-pronged to encompass wage growth and / or employment objectives. The RBA has posited wage growth consistent with full employment (3 per cent wage growth with an unemployment rate around 4 per cent).

The problem is that OBFG is just as inflexible as the inflation targeting framework based on forecasts. It is also just as problematic , for example, as saying the condition for a policy rate increase “will not be met before 2024” or “at the end of 2023.”

OBFG can unnecessarily constrain the central bank.

For one thing, it might mean the central bank only acts when the inflation genie is effectively out of the bottle. The pandemic induced supply shocks are coinciding with the reversal of structural trends that account for the deflationary tendency of the past three decades: viz; globalisation of labour supply (as well as that for goods and services) and baby boomer workforce participation. Add into that mix the secular rise in female workforce participation, and the result was a massive global labour supply shock and a decline in wage growth and a structural deflationary trend. That is ending. A move to OBFG – at least the way the RBA is framing it – might be a case of ‘fighting the last war’.

For another, the various ‘outcomes’ might be incompatible. For example, unemployment may remain relatively high because of geographic or skill mismatches. Monetary policy is impotent in such a circumstance. Having monetary policy target an unemployment rate under these conditions is a recipe simply for more inflation.

This is the lesson from the 1970s. Back then, by accommodating supply shocks, monetary policy ratcheted up inflation expectations putting pressure on limited supply leading to persistent inflation and a weakening economy. Little attention was given to structural approaches including, inter alia, assessments of the benefits of public and private infrastructure investments in physical and human capital.

The upshot for the RBA is that not only do the tactics need to change but a holistic review of monetary policy strategy, including how it complements other arms of policy, may be required. One that recognises that the context in which monetary policy is framed is replete with uncertainty and that monetary policy strategy needs the requisite flexibility to adjust to a myriad of unforeseen circumstances.  

Coming up: Bank of England (BoE) meets tonight.

  • US October non-farm payrolls on Friday.

The BoE meets tonight and is widely expected to lift the policy rate from 0.10 per cent to 0.25 per cent. That much is already priced by the market largely in response on ongoing upside inflation surprises in the UK and the limited prospect of any near-term dissipation of price pressures. Having said that, it is also expected there could be as many as three dissenters. Nevertheless, the differences in view are also unlikely to prevent the BoE to signal ongoing moves at subsequent meetings towards 0.50-0.75 per cent range.

For US non-farm payrolls, market expectations according to Bloomberg are for an increase in employment of around 450k (from a disappointing 194k in September) and an unemployment rate of 4.7% (from 4.8% in September). The private payroll data from ADP increased by more than expected in September at +571k versus +400k expected, although they are at best only a loose guide to the Bureau of Labor Statistics report. The data are potentially difficult to interpret as any disappointment in jobs growth may have as much to do with supply-side issues, as with any deficiency of demand. The ISM report noted that businesses reported labour supply constraints which may have accounted for at least some of the employment ‘weakness’. That notion is lent support both by the record number of vacancies (circa 10.5m) reported by the US Labor Department’s Job Openings and Labor Turnover (JOLT) Survey, anecdotal reports of stronger wage growth and greater than expected increase in average earnings in recent months, indicating that wage inflation may be taking root in the US. The average earnings number within the overall non-farm payrolls report will likely therefore be closely watched, with the market expecting an annual increase around 4.9%. Given ongoing price pressures such an average earnings number may intensify inflation concerns, particularly given the outsize increase in the prices paid in the ISM manufacturing report earlier in the week and the ISM non-manufacturing report overnight.

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