REUTERS/Jonathan Ernst
Outgoing Federal Reserve chairman Ben Bernanke, exiting stage left.
At its December meeting, the FOMC finally took the plunge and began tapering down its quantitative easing (QE) program, reducing the pace of monthly purchases it makes in the U.S. Treasury and mortgage-backed securities (MBS) markets by $10 billion to $75 billion.
The consensus forecast of Wall Street economists - per Bernanke's own comments at the conclusion of the December meeting - is that the FOMC will continue reducing bond purchases by $10 billion at each meeting, dependent on changes to the economic outlook, putting QE on track to disappear by the end of 2014.
Turmoil in emerging markets since the December meeting - and a string of weak U.S. economic data releases in the last few days - has some wondering whether the Fed will put the process on hold for now, but most consider such a scenario extremely unlikely.
With this policy path cemented into expectations, eyes are already turning to the next phase in the process of monetary policy normalization - when will the FOMC begin to raise short-term interest rates from the current target range between 0 and 0.25%, where they've been pinned since the financial crisis?
Thus, a key question regarding the FOMC's January policy decision is whether or not the Committee will seek to strengthen its forward guidance on the likely path of short-term interest rates.
Economists and strategists from Goldman Sachs, Morgan Stanley, Citi, and Société Générale weigh in below.
KRIS DAWSEY, ECONOMIST AT GOLDMAN SACHS:
On balance since the December meeting, data surprises have been modestly negative. However, the most notable disappointment?the December employment report?appears to have been significantly distorted by adverse weather, while many of the other negative data surprises since the meeting were second-tier releases. In contrast, the latest data on ISM manufacturing, core retail sales, industrial production, and the January regional Fed surveys have been encouraging. Our Q4 GDP tracking estimate currently stands at 3.2%. Driven entirely by private final demand, this rate of growth suggests solid momentum heading into 2014. In short, we do not think the Fed has significantly changed its thinking on the near-term trajectory of the economy.
However, modest changes to the statement's language could include the addition of "in recent months" in the sentence referring to further improvement in labor market conditions, implicitly recognizing the weaker December employment report. An explicit reference to the weather is also possible. On the positive side, the latest housing market numbers generally suggest that the recent run of softer data may be ending. As a result, the housing sector language might be upgraded to indicate that recovery "continued" rather than "slowed." We see little need to adjust the language on inflation.
VINCENT REINHART, CHIEF U.S. ECONOMIST AT MORGAN STANLEY:
As for policy, what to expect at the January meeting depends on your interpretation of what happened at the December meeting. Was old-school guidance the best Janet Yellen could cobble together given a divided committee? Or, was it Ben Bernanke's next-to-last pass at keeping comity among his committee?
We think it was the latter and expect Janet Yellen to be patient, one more time. The December FOMC statement was not elegant to read nor amenable to the formal expression of policy associated with the incoming chairwoman, but it conveyed her preferred stance of policy. The FOMC can repeat the message that rates will be kept low even as the unemployment rate gets lower and trim another $10 billion from their asset purchases to keep them on a glide path to zero this year.
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The hardest task for the Fed will be to keep yields from backing up as incoming data convey substantial momentum. But the threat of a rate back-up will make it easier for Yellen to corral her contentious committee. Over time, we expect policy communication will become more formal. The give and take of market protests and official push-back, however, are likely to make for a bumpy ride.
ANETA MARKOWSKA, CHIEF U.S. ECONOMIST AT SOCIETE GENERALE:
The FOMC will not be publishing its growth projections following this week's meeting but, as always, it will be updating the outlook internally. Given the evolution of the data, there is a very good chance that the outlook will be revised up, at least modestly. Back in December, the Fed implicitly assumed Q4 GDP of just 1.8%, which at the time was similar to the consensus estimate. After a series of monthly data releases, the consensus forecast has increased gradually to 3.3%, while our own tracking estimate now stands at 4.2%. Either way, growth probably averaged in excess of 3.5% in the second half of last year, surpassing even the most optimistic forecasts. We believe that some of that momentum will spill over into the FOMC's 2014 forecast.
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The FOMC surely knows this and will search for ways to further anchor short-term rate expectations. What can be done? The Fed has made it easy and listed all of its options in the January primary dealer survey. They include: (1) lowering the unemployment rate threshold; (2) more clearly conveying that inflation remains an important consideration in adjusting the fed funds rate; (3) providing further guidance on information relevant to determining the appropriate timing of the first rate hike after the UNR threshold is reached; (4) using medians of fed funds rate projections from the SEP to communicate the likely path of short-term interest rates.
We believe that option #1 would be most powerful in anchoring the front end of the curve and preventing rate hike expectations from spilling over to late 2014. However, there was little support for the idea at the December meeting, and it is unlikely that such a significant shift would be announced at a meeting with no press conference. Option #2 does not strike as very impactful, unless the FOMC introduces an outright inflation floor (recent studies found that a 1.5% floor would not be effective, but a 1.75% would). Option #3 seems to be a variation of the "well past" phrase introduced in December, and it seems too vague to be effective. We believe that option #4 is most likely to be implemented at this meeting.
STEVEN ENGLANDER, GLOBAL HEAD OF G-10 FX STRATEGY AT CITI:
Were the FOMC to ignore asset markets, and simply upgrade the growth outlook slightly along with the expected taper, domestic and foreign asset markets would continue to face pressure, but long rates would probably be dragged down by equities. However unintentionally, not mentioning the turmoil abroad would be viewed as Fed indifference, but the Fed's mandates do not include foreign economies. Conspiracy theorists may argue that the Fed will see a bright side in the combination of lower equities prices and weak EM as giving US housing a boost via lower mortgage rates. But the Fed is unlikely to see it that way, given the risk of such a strategy backfiring.
Explicit FOMC concern about the possible impact of EM and asset market developments on US activity, rather than just watchfulness, would be dovish and EM positive. The Fed has stressed its view that what is good for the US is good for the world, but that convinces no one abroad and few domestically, so the only issue is whether the Fed can find wording that simultaneously expresses serious concerns on spillover risk and remains non-committal. Irrespective of the wording, if investors walk away thinking there is only rhetoric and little possibility of a Fed reaction, asset markets will sell off. The compromise may be to hint at a strong policy reaction under a narrow set of circumstances.