By Nouriel Roubini, Sheryl King and Prajakta Bhide
Roubini Global Economics
May 29, 2014
Communication is one of the main tools at the Federal Reserve’s disposal in what will soon be the post-QE, post-Evans rule era, making it critical to assess the Fed’s ability to deliver a coherent monetary policy message. Even in normal years, the FOMC ( Federal Open Market Committee) struggles to deliver a clear view about the economic and policy outlook as its voting members rotate so frequently. Here, we analyze the communication challenge presented by the significant turnover of FOMC members, exploring the views of individual members and assessing the implications for core policy decisions.
Bottom line: While the mean FOMC voter is more hawkish this year than in 2013, the view of the median FOMC voter – more important for decisions – has not changed much. However, there is still some potential for market volatility induced by disparate and relatively unknown voices at the Fed, particularly with regard to the new vice-chairman, Stanley Fischer. We believe that Fed Chair Janet Yellen, a consensus-builder with a solid grasp of the Fed’s communication challenge, will be largely able to counter individual hawkish noises. Still, delivering a clear forward guidance message under these circumstances will be tricky during a critical period of policy normalization. Ultimately, we believe Yellen’s dovish views will prevail, but Fed communication and forward guidance may become less explicit.
Market implications: We do not expect a repeat of the bond-market gyrations experienced last summer, when the Fed signaled the launch of QE tapering and then did not deliver, but increased market volatility around Fed communication is a risk. As the central FOMC view is dovish, the risks are skewed toward sudden jumps in Treasury yields and equity market sell-offs on market commentary from new Fed speakers, particularly Fischer and some of the new hawks in the FOMC.
High FOMC Turnover Makes for Mixed Messages
In the post-Evans rule era, the Fed’s policy approach has returned to a more discretionary one, with no clear explicit or implicit policy reaction function upon which markets can draw. In recent years, the Fed’s communication strategy has been anchored by QE. But with QE set to end by Q4 2014, the Fed will no longer possess this quantitative policy tool.
Until such time as the Fed decides to take a policy measure again (mostly likely to be a hike in the policy rate), the policy stance will be one of watchful inaction, with the Fed and policy-watchers scanning the incoming economic data for signs that higher policy rates are warranted. In this vacuum, the Fed will rely heavily on communication, enhanced perhaps by a reverse repo facility and/or a term deposit facility intended to keep short-term interest rates anchored. With so much riding on communication, the potential costs of miscommunication are that much higher. (The turmoil in financial markets last summer – when the Fed botched the taper signal, sparking a “taper tantrum” – is a clear example of said costs.) Once the first policy rate hike occurs (perhaps sooner), the Fed will have to communicate to the markets what its likely policy reaction function will be with regard to the speed and pace of policy rate normalization.
In this context, the substantial churn in the composition of the FOMC of late merits close attention. Over the past year, 75% of the FOMC’s membership has changed – more than twice the normal rate. With so many new faces joining the committee, delivering clear policy and forward guidance will prove tricky – especially as the Fed exits QE and looks toward policy rate normalization. Fed Chair Yellen expressed it best when she said that effective forward guidance “…depends critically on [the Fed’s] ability to shape expectations of the future, specifically by helping the public understand how it intends to conduct policy over time, and what the likely implications of those actions will be for economic conditions.”
Delivering the message in a clear and consistent manner is always difficult for monetary policy makers. With a constantly changing roster of decision makers and varied views on how monetary policy should be conducted to achieve policy goals, the message becomes all the more muddled. At least four FOMC voting members, the Fed bank presidents, rotate on and off the board of governors every year, and governors on the Fed board rarely serve a full 14-year term, meaning that even in normal years the FOMC is susceptible to criticism regarding muddled messages.
The rate of FOMC-member turnover has been particularly high over the past year, which has seen the departure of three board members (Chairman Ben Bernanke, Sarah Raskin and Elisabeth Duke) and Governor Jeremy Stein, along with the retirement of Cleveland Fed President Sandra Pianalto at the end of May. As a result, three seats on the committee have changed in the past year, on top of the normal rotation of four of 12 Fed bank presidents per year.
The rotation in Fed presidents does not present too much uncertainty: Even non-voting members speak to the public regularly, so their views on the economy, markets and monetary policy are well known. However, the views of the other new FOMC members are much less familiar.
The FOMC: Known Unknowns
There are two important factors to consider: First, the individual views of the new and prospective FOMC members, which could tilt the FOMC in a more hawkish or dovish direction; second, the new rotation’s potential influence on the FOMC’s decision-making core, led by Yellen.
The question of who will succeed the departing FOMC members is only partly settled. Loretta Mester, a long-time staffer (head of research and chief policy advisor to Charles Plosser) at the Philadelphia Fed, takes the helm of the Cleveland Fed in June; and former Bank of Israel Governor Stanley Fischer has been confirmed by the Senate to become Board vice-chairman. Lael Brainard, the under-secretary for international affairs at the U.S. Treasury and a former senior member of the National Economic Council, is a nominee for governor. She has yet to be confirmed, but is expected to be sometime in June.
Two more members of the board need to be nominated and confirmed to fill up the body’s seven positions. The Obama administration is likely to choose relative doves – i.e., policy makers who care about both inflation and growth/unemployment and would likely vote in similar ways to the FOMC’s current dovish members. Among the names floated as probable candidates for the board are several distinguished academics: Christina Romer and Alan Krueger (former heads of the Council of Economic Advisors, or CEA, in the first Obama administration) and Janice Eberly (formerly an official at the U.S. Treasury). One of the two open board slots is likely to go to a community banker; Yellen has expressed support for this idea, which is popular in Congress. Traditionally, community bankers are dovish, and they tend to agree with the views of the rest of the board members.
Starting this year, the profile of regional Fed presidents on the FOMC has become less dovish – three new relative “hawks” are in: Charles Plosser from the Philly Fed, Richard Fisher from the Dallas Fed and the new Cleveland Fed head Loretta Mester, who used to be Plosser’s policy advisor at the Philly Fed; only one hawk is out, namely Esther George from the Kansas City Fed. So, the mean FOMC voter is now more hawkish than in 2013.
Fischer: Master of Activist Monetary Policy and Forward Guidance Doubter
The new vice chairman, Stanley Fischer, was responsible for some of the earliest work on activist monetary policy. While leading the Bank of Israel (BI), he aggressively lowered policy rates in early 2008 as the credit markets went into meltdown and then had to reverse course soon after with higher rates and massive currency intervention as the shekel surged in response to the ensuing rapid economic recovery.
Fischer is uncontroversial when it comes to his views on the U.S. economy, which are mainstream. It is his skeptical views on the effectiveness of forward guidance that set him apart, introducing a note of uncertainty into the FOMC. He contends that forward guidance is not credible when the central bank cannot effectively predict the future, and therefore a commitment to keep policy rates low for longer is not very credible if it diverges from the policy reaction function of the central bank. For that reason, Fischer has argued that providing guidance gives the central bank less flexibility when some state-contingent discretion is necessary. Fischer downplayed these views before the Senate Banking Committee, but they could very well remain valid in his mind. He is of the view that the Fed may have over-communicated its policy intentions to the markets, a potentially counter-productive effort that may have made investors too reliant on Fed signaling.
As Yellen is still a strong proponent of forward guidance and transparent communication, FOMC meetings could prove lively as Yellen and Fischer have differing views about forward guidance. At worst, any public comments Fischer may make on the subject could be seen as signaling friction within the FOMC. Ultimately, however, we believe Yellen’s views will mostly prevail, but Fed communication and forward guidance may become less explicit and direct.
Brainard: Likely to Align Well With Dovish Yellen
Brainard’s views on monetary policy are essentially unknown beyond her circumspect opening statement on the subject during her appearance before the Senate Banking Committee. However, her work on poverty and income disparity at the Brookings Institution suggests that she tilts toward dovishness and is generally sympathetic to interventionist policies. Her stint as under-secretary for international affairs at the U.S. Treasury indicates that she will bring a wealth of experience on global economic and market issues.
Mester: Possibly Hawkish Like Plosser
The monetary policy views of the new Cleveland Fed president, Loretta Mester, are also little known, but we believe they are skewed toward the hawkish end of the spectrum. Since Mester retained her role under Plosser, the hawkish Philly Fed president, it seems likely that her views align with his.
Her speeches on the economic outlook have not strayed far from the central tendency of Fed forecasts, but a speech she gave last year reveals some reservations about forward guidance and macroprudential policy tools. Mester pointed out that forward guidance may not work in practice since in the real world there is no perfect commitment (a view shared by Fischer), although she acknowledged that QE played a role in helping to bolster the Fed’s future commitments. She is even less convinced that monetary policy has a role to play in financial stability, as it is difficult to see a bubble forming in advance. She argues that macroprudential tools are in their infancy and it is difficult to calibrate the magnitude of policy needed to assure financial stability. Finally, Mester discussed the Fed’s independence, pointing out that in the future, the central bank may face political pressure to remain in accommodative mode; she also touched on the political implications of a sensitive potential scenario in which the Fed is paying interest on excess reserves to banks while making zero or net negative remittances to the Treasury from its balance sheet.
Nonetheless, having attended most FOMC meetings in her prior role as head of research at the Philly Fed, Mester is well acquainted with the committee’s inner workings.
The Fed Now Less of an Absolute Monarchy Than Under Greenspan
Under Alan Greenspan, the FOMC was close to an absolute monarchy as the views of the chairman were dominant and accepted by the rest of the committee. Under Ben Bernanke, the FOMC became a cross between a constitutional monarchy and a collegial democracy, as the chairman had to work hard to ensure that his views were shared by the majority of the FOMC. That required a constant dialogue between the chairman and the rest of the Board to ensure that a majority of the FOMC would agree with the chairman’s views. Bernanke was frustrated by the cacophony of views expressed by FOMC members – voting and otherwise – and he instituted press conferences in part to ensure that investors were clearly aware of the FOMC’s central view, despite the noise coming from speeches and public comments made by individual FOMC members. Close interactions between board members at least ensured some coherence of views within this group, but, even with the press conferences, the Fed cacophony never stopped as regional Fed presidents continued to express publicly views that differed from the FOMC median.
Under Yellen, the Fed will remain as much of a constitutional monarchy (or possibly even a collegial democracy) as it became under Bernanke. Yellen has a collegial personality and approach and will work hard to ensure that she takes views close to those of the rest of the FOMC. For example, she has previously expressed sympathy for the idea of optimal control – i.e., allowing inflation to increase above the Fed’s 2% target to allow the unemployment rate to fall below the non-accelerating inflation rate of unemployment (NAIRU) for a while, thus allowing a faster reduction of labor-market slack generated by years of low employment. But the idea of optimal control never garnered a majority within the FOMC, as there is a risk that once inflation rises above target, inflation expectations would become unhinged. Thus, as Fed chair, Yellen has already stopped supporting optimal control, a shift in stance from her days as vice-chair. She also aligned herself with the rest of the FOMC in December – before becoming chair – by supporting the start of QE tapering.
The FOMC Still Has a Dovish Majority
The Fed chair still wields significant power and is likely to have a board that remains relatively dovish: indeed, under Bernanke, the board became more dovish over time and moved closer to Yellen’s views. In spite of all the changes, the voting FOMC still has a majority of relative doves (Daniel Tarullo, Jerome Powell, William Dudley and Narayana Kocherlakota, as well as Fischer and Brainard when confirmed) who will align with Yellen’s views on the economy. Once the two additional board vacancies are filled by Congress, this dovish majority will be reinforced.
In her April 16 speech to the Economic Club of New York, Yellen offered a detailed explanation of the central bank’s current thinking on forward guidance and policy rules, and set the groundwork for a coherent forward guidance message. Coming after her remark about a six-month lag between the end of QE and the start of rate hikes, Yellen’s speech was a form of corrective action, highlighting the high degree of labor-market slack and the weak inflation outlook; the market correctly interpreted these signals as dovish with respect to policy rates.
Fed Must Next Devise a New Policy Rule
With markets and investors now focusing on the date of the first rate increase – as the tapering schedule is on track to be completed by October – the key issue for the Fed will be to communicate to markets which rule will be followed regarding the pace and end point of policy normalization once rate normalization begins. With regard to the end point, the neutral long-term fed funds rate will be closer to 4% than the higher levels (5.25% and 6.5%) seen during the last two cycles. A 4% neutral fed funds rate is consistent with a 2% inflation target and a 2% real fed funds rate. Historically, the equilibrium real fed funds rate was higher (closer to 2.5-3%), but Fed officials have made several arguments for why the equilibrium real short rate is now closer to 2% – if not lower.
As recently argued by New York Fed President William Dudley, there are three reasons for a lower equilibrium real fed funds rate. First, economic headwinds seem likely to persist for several more years. Second, slower growth of the labor force and moderate productivity growth imply a lower potential real GDP growth rate, which implies lower real equilibrium interest rates even once all current headwinds have fully dissipated. Third, changes in bank regulation may also imply a somewhat lower long-term equilibrium rate. Higher capital requirements for banks imply somewhat wider intermediation margins, which is likely to push down the long-term equilibrium federal funds rate somewhat.
Some very dovish FOMC members may believe that the equilibrium fed funds rate may be even lower than 4% (a view that is currently priced in by financial markets), while some more hawkish members believe that an equilibrium rate closer to the historical average of 4.5% is more warranted. This dispersion of views is clear from the forecasts contained in the FOMC’s Summary of Economic Projections (SEP). But for the median FOMC voter, the new neutral rate is 4%, so it seems likely that this will be the neutral rate.
How fast will the Fed get to 4% and with which policy rule? The median FOMC voter sees the fed funds rate at 1% by the end of 2015 and 2.25% by the end of 2016, only reaching the neutral level of 4% toward the end of 2018. This is an extremely slow pace of policy normalization, a process that would last about 3.5 years from start to finish, assuming normalization does not begin until mid-2015. In the 2004-06 normalization cycle, the rate went from 1% to 5.25% in just two years.
The need to use aggressive forward guidance – low for longer relative to even a modified Taylor rule – to make these SEP projections credible to markets is obvious: Since the median FOMC voter forecasts that the unemployment rate will be close to NAIRU by the end of 2016 and that inflation will be close to its 2% target at that time, a fed funds rate of 2.25% by the end of 2016 implies that the real fed funds rate will still be close to or barely above 0%, despite the economy being close to full employment and inflation being close to target. In normal times, such a scenario would have justified a real fed funds rate closer to 1% and therefore a nominal fed funds rate that is closer to 3% than 2.25%. And indeed, some analysts and market participants believe that the Fed will normalize faster than the SEP dots (individual participant’s forecasts) predict, with the fed funds rate close to 3% by the end of 2016.
This is why Fed communication and forward guidance are key. If those within the FOMC who are skeptical of forward guidance (such as Fischer and the hawks) were to have the upper hand, it is likely that markets would start pricing in a more rapid policy rate normalization – closer to 3% by the end of 2016 and closer to the neutral rate of 4% by the end of 2017. If instead, the dovish view were to prevail, it would be critical for the Fed to defend the credibility of its “lower for longer” message.
Those skeptical of forward guidance would most likely prefer the Fed to communicate to markets a policy rule closer to a Taylor rule with some discretion, rather than a policy rule based on strong forward guidance. Therefore, the key issue ahead will be whether Yellen can convince the rest of the FOMC to maintain the “lower for longer” forward guidance approach. While the median FOMC voter currently adheres to the Yellen view, the situation may change for several reasons:
The less dovish members may push to de-emphasize forward guidance and the SEP dots;
As uncertainty recedes about the end-2016 outlook for inflation and labor-market conditions, the policy reaction function of the median FOMC voter may change: that median FOMC voter may decide that a near-0% real fed funds rate is too low and would thus choose to front-load the policy rate normalization process toward 3% by the end of 2016;
Concerns about asset bubbles and financial stability may induce FOMC members to consider using monetary policy to control bubbles, especially if macro-pru policies fail to contain current and future frothiness in financial markets. While Yellen is wary of using monetary policy (policy rates) to control bubbles, other FOMC members are more open to this option if macro-pru policies prove insufficient.
Therefore, for the FOMC to make its multi-indicator-based forward guidance approach work, we believe that the members will need to follow Yellen’s lead and make a stronger and more cohesive effort to communicate the FOMC’s policies and views on the economy. If Yellen continues to communicate in this manner, and is able to rally the overall signaling of the Fed’s stance around her views, then the Fed may be able to temper the headwinds generated by the current absence of a more explicit policy framework. If not, we would be concerned that a somewhat less dovish FOMC membership may have an impact on the market’s perception of the timing and speed of the Fed’s policy normalization and the degree to which the Fed will continue with forward guidance in the future. Certainly, the Fed is now in the middle of a serious debate on the nature of its policy reaction function once policy rates start to rise above 0%. The result of this debate will be key to assessing whether the pace of policy normalization currently priced in by markets – that is, close to the Fed’s SEP dots – is correct or not.
The Known Knowns
Although the market will have to adjust to a number of new Fed officials over the next year, the FOMC’s 2014 and 2015 cohorts contain a number of familiar figures. Below is a summary of their current views on how monetary policy should evolve over the next few years.
New York Fed President William Dudley is a dove and a core member of the FOMC. In a speech on May 20, Dudley did not add color on the timing of the first rate hike, but noted that the pace of tightening thereafter “will probably be relatively slow.” Dudley expects that the fed funds rate consistent with a 2% rate of long-run personal consumer expenditure (PCE) inflation is likely to be well below the 4.25% historical average that accompanied 2% inflation. (With respect to the labor market, Dudley noted that he believes a much greater proportion of long-term unemployment is the product of cyclical forces.) Dudley is likely to align with Yellen in pressing to keep rates “lower for longer.”
San Francisco Fed President John C. Williams will be a 2015 voting member, and therefore likely to play a role in the forward guidance debate in 2015. In a May 22 speech, Williams noted that “a real tightening of policy – which would mean raising the fed funds rate – is still a good way off.” Although Williams is dovish, he is a mild dove at best and may have views diverging from the “lower for longer” pledge; for instance, Williams had seemed to be leaning in the direction of an expeditious retreat from QE last spring.
Dovish Atlanta Fed President Dennis Lockhart will be a voting member in 2015 and is likely to support “lower for longer” forward guidance. In a May 11 speech, Lockhart said that the first rate hike would likely come in H2 2015, stating that “When the first move to tighten policy is taken, I would expect it to begin a cycle of gradually rising rates.” Lockhart sees both a shortfall from potential and below-objective inflation as justifying patience in raising policy rates.
Chicago Fed President Charles Evans is markedly dovish and a clear proponent of forward guidance. As a 2015 FOMC voting member, he will be strongly in favor of maintaining forward guidance to shore up the recovery. In an April 9 speech, Evans observed that “It certainly seems that the fallout from the financial crisis and persistent headwinds holding back economic activity are consistent with the equilibrium real interest rate being lower than usual today.” In Evans’ view, the FOMC’s March “lower for longer” pledge accounts for the possibility of lower real rates.
Richmond Fed President Jeffrey Lacker is generally hawkish, although he has not spoken recently regarding the Fed’s March communication changes on interest rates. He votes in 2015, and may lean against the forward guidance pledge.
Philadelphia Fed President Charles Plosser is a hawk and a member of the FOMC in 2014. In a May 20 speech, Plosser said that “as we continue to move closer to our 2% inflation goal and the labor market improves, we must be prepared to adjust policy appropriately. That may well require us to begin raising interest rates sooner rather than later.” Plosser’s next voting term is in 2017, however, and therefore he will influence the debate (rather than the vote) on “lower for longer.”
Minneapolis Fed president Narayana Kocherlakota, a 2014 voting member, is a hawk turned noted dove. In a May 21 speech, Kocherlakota stated that he currently saw the Fed as undershooting both its price stability and maximum employment mandates. Kocherlakota’s next voting term is also 2017 and therefore, like Plosser, he will influence the debate rather than the vote on “lower for longer.”
Finally, there is Dallas Fed President Richard Fisher, who is currently a member of the FOMC and also a noted hawk. Fisher has never been a proponent of QE, long arguing that Fed asset purchases can lead to excessive risk taking and the creation of market bubbles. As Fisher rotates off the Committee this year and will not be a voting member again until 2017, his views will have less bearing on the timing and pace of rate hikes over the next couple of years.
