Fed Watch: Dissent

The FOMC statement contained a mini-bombshell, the dissent of Kansas City Fed President Thomas Hoenig. I am skeptical, however, that this dissent is a significant shift in the policy environment. Instead, I view the statement as taking another baby step forward to a normalization of monetary policy now that the financial crisis has eased and that the economic environment has firmed. Many policymakers will simply find themselves increasingly uncomfortable holding rates at rock bottom levels while sitting on a bloated balance sheet – regardless of the unemployment rate. Short of a significant reversal of recent economic gains, I would be hard pressed to see the Fed back away from a policy stance that is growing tighter, albeit slowly tighter.

The opening sentence of the statement maintains the position that the economy continues to strengthen while labor markets firm. Some may be surprised about the latter point given the disappointing December employment report. The Fed, however, will be expecting the road to sustained improvement to be bumpy; one month will not significantly impact their outlook given the sharp decline in the pace of job losses in the second half of 2009. The trend is clear. The Fed also upgraded slightly its assessment of business spending, consistent with data such as new orders for capital goods.

The opening paragraph, however, omitted mention of the housing market improvements as noted in the December statement. Are they less confident of a sustained rebound given the drop off that followed this summer’s tax credit induced boom? Or do they just want to avoid mention of housing given that they intend to halt stimulus for that sector? In my opinion, of all the Fed interventions over the past year, the decision to acquire $1.25 trillion of mortgage securities is the most politically risky; more on that later.

Also dropped is the mention of monetary and fiscal stimulus. From December:

Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.

This evolved in January to:

Although the pace of economic recovery is likely to be moderate for a time, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability.

Certainly, it is no secret that the Fed is closing some of the emergency funding facilities (as noted later in the statement). Nor is it a secret that the Fed intends to halt its securities purchases and that fiscal stimulus will wane in the coming months. But the withdrawal of this support, however, does not appear to significantly impact their fundamental outlook of steady improvement. In other words, they appear to believe the economy can stand on its own – an important precursor to normalizing policy.

That expected improvement, however, will be slow enough to keep policymakers focused on stemming the balance sheet expansion long before raising interest rates. Hence the continued reliance on the phrase:

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

It is widely expected that the Fed would remove the last clause of this sentence before embarking on any campaign to raise rates. And it is here that Hoenig caused something of a stir by objecting to this promise to hold rates low while accepting the current stance of policy. But Hoenig’s views are not exactly a secret; he stepped up the hawkish rhetoric this month. He likely remains an outlier on the FOMC; note that it is likely there are outliers on the other side. St. Louis Fed President James Bullard, for instance, has indicated that he is uncomfortable moving to a blanket exit from balance sheet expansion, instead preferring a more state dependent policy that promises to adjust up, down, or steady as necessary. Indeed, he has repeatedly emphasized that interest rates should not be the focus of investor concern. Hoenig, of course, easily undid Bullard’s work today and shifted focus back on rates.

I find it inconceivable that the Fed would be keen on normalizing rate policy without a substantial decline in unemployment, absent of course an unexpected surge of inflation. But the balance sheet is another issue. We can debate nonstop the merits of allowing inflation expectations to rise through sustained expansion of the balance sheet, but the Fed simply is not going there without clear evidence that deflation is the bigger risk than inflation. And note that this is not the direction the Fed is thinking – the FOMC statement now sees it as only “likely” inflation will remain subdued, a slightly less certain statement compared to December. The Fed is ceasing expansion of the balance sheet in general and specifically halting its support of housing. The longer the economy exhibits signs of sustained growth – even anemic growth – the more the Fed will tend toward stepping up the pace of balance sheet contraction.

And therein lies a political problem greater than AIG and other financial market interventions. The Fed already plans to halt housing support and expects interest rates to rise. Policymakers are playing with fire here; more than any other sector, housing is considered sacrosanct among politicians. From the WSJ:

In its current buying spree, the Fed has spent most on supporting housing. Consider what might happen if the housing market starts to sag again–as recent numbers suggest is possible–and politicians call for extra support. If the Fed then reinstated mortgage buying, it would look like it was bowing to political demands, even it was actually doing so for purely monetary reasons.

Theoretically, reversing the balance sheet should not be a problem. The Fed can sell back what it bought. Moreover, officials believe tools such as interest on reserves would be effective in keeping sufficient money tied up in reserves even if financial market conditions precluded rapid asset sales. But what if the Fed is already at a point where it is politically impossible to sell mortgage based assets on any significant scale? Perhaps this explains the runup in inflation expectations in financial markets despite high unemployment and policymaker’s repeated assertions that they effectively place more weight on low inflation than high unemployment. Financial markets may already anticipate that the Fed’s independence was effectively lost the instant they explicitly and massively supported the most politically important sector in the economy. To be sure, academics can argue that such support was necessary to support asset prices and compensate for a very sector specific financial disruption. But backing out by definition means reversing support for that same sector, perhaps directly contributing to a rise in rates that threatens the very market the government is struggling to hold together. AIG could seem like small potatoes compared to the furor that would erupt if the Fed undermines this struggling sector.

Bottom Line: The Fed is crawling ever so slowly to the inevitable in the current economic environment – normalizing monetary policy. Still, the normalization of rate policy is a long way off given the uncertainty over the pace of activity in the second half of this year and the expected persistent high rate of unemployment. To be sure, some policymakers will be eager to move more aggressively, but I think the data would need to be much stronger for this idea to move more broadly through the FOMC. The Fed will first gauge the financial and economic consequences of balance sheet normalization before they turn their attention to interest rates. Given that the Fed is growing increasingly confident that the economy can stand on its own in the absence of stimulus, the Fed is very unlikely to move into a more aggressive stance, despite high unemployment rates.

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