Federal Reserve: Uncertainty Squared
The uncertainty about the Fed reaction function should be concerning for markets. The next evolutionary step from the Fed will be removing the easing bias in June.
It’s getting spicy on the FOMC. And that’s before Kevin Warsh is even confirmed. Three members marked out their turf on Wednesday by objecting to the “easing bias” in the Statement.
Growth and output assessment unchanged, inflation assessment worsened
While the statement previously described inflation as “somewhat elevated,” now it’s “elevated,” which is more concerning. Ascribing part of inflation to recently higher global energy prices might sound too much like “transitory” to the hawks, even though it’s a fact, not a judgment. Since the growth and labor market assessments remain unchanged, the statement was more hawkish on the economy.
More uncertainty
Like last month, the statement emphasizes uncertainty about the outlook, though it has now cranked up a notch from being “elevated” in March to “high level” in April. The statement said, as in March, “The Committee is attentive to the risks to both sides of its dual mandate.” The hawks may have wished for an assessment that paid more attention to inflation risks.
The easing bias remains…
The easing bias has been there for months and months, and the Gang of Three feel it’s sell-by date is well and truly passed. The text continues to include, “In considering the extent and timing of additional adjustments to the target range for the federal funds rate” (my emphasis). That’s an easing bias because the most recent moves have been cuts, so “additional” means “more cuts.”
… which is what the hawks object to
Given the upsurge in energy prices and inflation, the hawks’ position is that the balance of risks has shifted, especially regarding inflation, and therefore presuming the next move is a cut is too dovish. However, the rest of the FOMC clearly see the current supply shock as bad for growth and inflation, with Stephen Miran voting for a cut. The majority of the FOMC is in wait-and-see mode, whereas the hawks feel we’ve already seen, earlier this decade, how this movie ends.
Dissent signals more change to come
What does the split mean for the Fed’s future policy stance? With Jerome Powell deciding to stay on the Board after his term as Chair ends, Stephen Miran, the uber-dove on the committee, will be out. On the reasonable assumption that Warsh will be less dovish than Miran, the bias of the committee will edge more hawkish, by how much depending on Warsh’s stance.
While split votes are not decisive, they have been the precursor to policy shifts in the past, important examples being:
2007-2008. Dovish dissent. Before the Fed started aggressively cutting during the financial crisis, there were internal disagreements about how serious the downturn was.
Some officials wanted to cut sooner as risks mounted. Fred Mishkin wanted an easing bias at the August 2007 meeting. Others were still focused on inflation risks. Result: dissents increased, and the Fed pivoted to rapid rate cuts in September.
2014-2015. Hawks dissent. During the recovery after the Great Recession, several regional presidents dissented because, becoming more confident in the economy, they wanted rate hikes earlier than the still-cautious majority. The first dissent was James Plosser in August 2014. Result: the Fed began its first rate hikes in December 2015.
2018. Doves dissent. Pre-pandemic, disagreements emerged, more in tone than votes, in mid to late 2018, with some policymakers warning of over-tightening while others supported continued hikes. Result: within months, the Fed paused and then reversed course in July 2019.
The evidence suggests that while turnarounds in rate action can follow hot on the heels of a dovish dissent prompted by financial stress, a turnaround can take time - central bankers don’t want to flip-flop, especially when uncertainty is high. The shortest gap between the last cut and the first hike is 6 months; the last cut in this cycle was in January.
Dissents are important information because they reflect differing interpretations of the weight of emerging evidence. Some participants feel the evidence is conclusive enough to change their view. For others, the necessary threshold has not been reached for that, but that does not mean that they have not shifted in the same direction. Three dissents at the April meeting suggest that others may well be close to the edge in wanting to remove the easing bias. The FOMC may be even more data-dependent than normal.
June FOMC: bye-bye easing bias
Given the impasse over the Straits of Hormuz, which may require further military action to break, and the possibility of infrastructure damage, news on inflation between now and the next meeting will be poor. Unless there is a big shift in growth dynamics or market stress, softer news on the real economy will not offset that. Thus, my assessment is that the news will be sufficient to persuade more members to remove the easing bias. My judgment of the chances of the June outcome is:
Easing bias removed -80%
Easing bias language toned down - 15%
Easing bias unchanged - 5%
The next FOMC is June 16-17; the Senate vote on Warsh’s appointment on May 11, and Powell’s term ends May 15, with yesterday’s press conference being his last. Will Warsh be comfortable removing the bias, given his view that AI will reduce the neutral weight and that rate policy might need to ease to offset the shrinkage in the Fed’s balance sheet that he wants to see? Or would he see a continued pause as useful credibility building, allowing him to cut rates later without adverse term premium implications? How would that tie in with the President’s desire to see lower rates, especially ahead of the midterms? We’ll get a firmer steer on the new Chair’s views not only at the June FOMC but also in the semi-annual testimony to Congress in late June/early July.
Removing the bias would take easing off the agenda for a few months, unless the economy worsens dramatically, because the Fed will not want to remove the easing and quickly put it back in without compelling evidence. But it would not put hiking on the agenda. Essentially, it would be a formalization of the Fed’s current wait-and-see stance. That would be useful for the Fed as it weighs options for the balance sheet and how that should mesh with rate policy. During that period, the Chair can carefully steer market views to help avoid future surprise decisions.
Uncertain outlook times uncertain reaction function = uncertainty squared
The debate about which is the larger risk - inflation or growth - is unlikely to be settled in the near term, so the tension we have seen weighing inflation against growth risk is likely to continue. That may unsettle markets. How do you price long-term assets if one of the fundamentals of the assessment, the Fed reaction function, is up in the air? When uncertainty about the economic outlook is multiplied by the uncertainty concerning the Fed's response to that outlook, the overall uncertainty in the system increases exponentially. That is a recipe for a potential accident in markets. Warsh needs to make his stance clear and to avoid a damaging split on the FOMC