Four Dimensions of the FOMC Meeting

The FOMC meeting is the week's highlight even though policy outcome seems a foregone conclusion. It will continue with the tapering course that Bernanke put on the Fed on before he left. However, there are more moving parts than usual, and it is worth reviewing.

Essentially, there are four elements of the FOMC meeting: composition, statement, forecasts and press conference.

Composition

Conventional wisdom holds that the Fed differs from the ECB in that it has two mandates instead of one and focuses on core inflation rather than headline inflation. We argue these are superficial differences. It is ironic, though, how easy, even now, that the Fed's third mandate--financial stability--is not included. In any event, the Fed takes into account headline inflation and the ECB does not ignore core inflation.

The more significant difference we argue is that the ECB has a small governing board, and the national central banks are more numerous. The Federal Reserve has a strong central governing board and weaker representation of the regional presidents. However, because of arguably excessive partisanship in congress, there the Federal Reserve Board of Governors has been understaffed. Even with the latest confirmations there are two vacancies on the seven-member board. This has given the regional presidents more attention, and their views tend to be more extreme as the record of dissents shows.

Generally speaking, the composition changes have led most to see a slight dovish tilt. The retirement of Stein, who was seen as to the hawkish side of the narrow spectrum of the Fed and the arrival of Brainard, a perceived dove, is the source of the judgment. We demur and suggest the Board of Governors remain pragmatic centrists. While there may be fifty shades of gray, in this context gray may be gray. And what does it really mean to be dovish amid a winding down of QE3+ and preparing for a normalization of monetary policy?

There has been some suggestion that Brainard having just been confirmed late yesterday may not be ready to participate in the forecasting exercise. This may not matter when it comes to the crunching the numbers.

Statement

The economy has largely unfolded as the Federal Reserve expected since the April meeting. The headwinds evident in Q1 were perhaps more than the FOMC anticipated, but the factors were transitory as it suggested, and growth has rebounded well. The labor market has continued its gradual improvement, but broader indicators suggest that slack remains. The housing sector continues to disappoint, and business investment remains soft. Some minor tweak of this assessment may be in the statement.

The forward guidance that see interest rates remaining low for "a considerable" period of time after the asset purchase program ends is likely to remain. The Fed will most certainly announce another $10 bln of tapering to bring the asset purchases to $35 bln a month through the end of July, when it will taper another $10 bln. The Fed will argue that accommodation is still necessary.

Forecasts

There is a high degree of uncertainty about the economic outlook. Consider what we have already experienced this year. When Q1 GDP was initially estimated, it grew a miniscule 0.1%. That was revised to a 1% contraction, and now it appears set for another sharp downward revision following the recent consumer services spending report. However, there is considerably less uncertainty about the Fed ceasing asset purchases later this year.

So, arguing backwards, organizational behavior, if not consistency, suggest that in order to change policy, Fed officials have to believe that it is approaching its mandates. To be clear, these mandate are not growth per se, but full employment and stable prices. This is what the forecasts are likely to reflect.

First, dismal Q1 GDP is going to force the Fed to cut this year's forecasts from the 2.8-3.0% expected in March. The IMF can a preview of what to expect when it announced yesterday was cutting US growth from 2.8% to 2.0%. The Fed may also take advantage of the opportunity to lower its 2015 and 2016 forecasts as well. The issue here is that the Fed has habitually been more optimistic than the market and has consistently revised down its forecasts. The central tendency for 2015 was at 3.0-3.2%, which seems to be on the high side, for example. The combination of slower labor market growth and lower productivity translates into prospects for sub-3% growth on a sustained basis.

Second, if the Fed has been too optimistic on growth, it has not been optimistic enough on employment. In March, it offered a central tendency on of 6.1-6.3% for 2014 unemployment. In May unemployment stood at 6.3%. Seemingly paradoxically, while the Fed cuts its growth forecasts, it will reduce its unemployment forecasts. The lower end of the range is likely to be 5.8-5.9%. There may be a knock-on effect on the 2015 forecast of 5.6-5.9% as well.

Third, the core PCE deflator forecast may be tweaked higher. The central tendency in both the December 2013 and March 2014 forecasting exercises put it at 1.4-1.6% this year. It stood at 1.4% in April. A small upward adjustment seems warranted. Benchmark effects alone will likely see core PCE firm.

Press Conference

Yellen's press conference in March will be remembered for her momentary lapse from the strategic ambiguity and the use of purposely vague words like "considerable period." Yellen will likely emphasize that the Federal Reserve continues to believe accommodation is needed.

After the Bank of England Governor appeared to shift from a dovish to a bearish forward guidance stance, many observers wonder if Yellen will play the same card. Color us highly skeptical. Some measures of the UK labor market show greater recovery than the US and its housing market is considerably stronger. The UK economy also did not contract in Q1, while the US contraction could have been close to 2% on an annualized basis.

Carney and other central bankers have tried to play up forward guidance, but it is not really that different from what central banks have long done; namely help shape business and investor expectations. It was never a commitment, and it always has been flawed by what economists euphemistically call "time inconsistencies." We expect Yellen to stay on message, the tapering continues in a measured way to ensure the economic recovery remains on track.

The December 2015 Fed funds futures implied an effective funds rate of 71 bp on April 30, when the FOMC last met. At the end of May, it stood at 55 bp. As the 2-day FOMC meeting gets underway, the contract implies a 77 bp effective funds rate at the end of next year, which is essentially two hikes. Given that the dot plot in March showed a 1% Fed funds rate by the end of next year, it seems prudent that the implied rate has increased ahead of this FOMC meeting. However, we would not be surprised if the dot-plot eases back to 75 bp (perhaps with the help of the changed composition and the steep contraction in Q1 GDP and the same factors that prompted the IMF yesterday to suggest the Fed has room to keep the funds rate near zero beyond current expectations).