Rosy scenarios, Monetary policy, and Trump

Another year of well-disguised, steady predictability in Fed policy is in the books, and the FOMC hit the trifecta at the December meeting. The Fed did what policymakers had clearly indicated they would do; the FOMC said what any reasonable policymaking body would say under these circumstances; and the dots, as usual, created a carnival of confusion.

What the Fed did. Pretty much everybody had gotten the message that a rate increase was coming if the economy stayed broadly on track. The fact that the move was coming under these circumstances had been clear in Fed communication since mid-August, and became increasingly clear as the scenario played out.

What the Fed said. The bizarre atmosphere surrounding all policy since the election made the main elements of the FOMC’s message a no brainer. The macro data in hand had not changed much since the previous FOMC. Combining this with the circus atmosphere, any sensible FOMC would make minimal changes to the FOMC statement: the economy is doing roughly what we expected, so we’re doing what we signaled. Enough said.

Of course, at the press conference, Yellen was going to have to say something about the policy implications of the election. The 17 policymakers were likely to have a range of views about this, and only collective masochism would have compelled them to attempt to resolve these differences now, given that there was no policy need to do so. As I argued before the meeting, wait and see, at least for a time, is the natural outcome.

Or as Yellen put it,

[A]ll the FOMC participants recognize that there is considerable uncertainty about how economic policies may change and what effect they will have on the economy … But we’re operating under a cloud of uncertainty at the moment, and we have time to wait to see what changes occur and to factor those into our decisionmaking as we gain greater clarity.

Thus, both the Fed action and the statements on behalf of the consensus were perfectly consistent with the steady predictability that the consensus of the FOMC has shown for a few years. And then there is the well-disguised part.

The carnival of confusion surrounding the dots. In advance of the meeting, it was clear that SEP would provide ripe material for misinterpretation and that the median dot would be even less meaningful than usual. I’ll admit, however, that I would never have predicted the complete absurdity of what people made of the dots. There are some insights to be gained in this absurdity.

First, the facts. The central tendency for the 2017 dots fell a bit. OHMIGOD, the hawks are in retreat! But the median 2017 dot rose a bit. OHMIGOD, they’ve pivoted to rapid tightening. The truth, as Yellen emphasized, is that the nothing of any importance was signaled in the dots.

The SEP forces the projectors to pick one most likely scenario and then to report the appropriate policy under that scenario. Let me repeat that: the SEP demands that each policymaker pick one particular manner that uncertainty is resolved over the projection horizon. Then the dots focus a bright light on the likely policy implied under the mish-mash of 17 choices of the most likely scenario chosen by the policymakers.

But picking one Trump policy scenario right now cannot be much more reliable than blindfolded dart throwing. No sensible policymakers would let those choices drive policy. Instead, they’ll collectively try to do what’s best in light of the collection of 17 most likely cases and in light of other important scenarios, some of may be very likely as well. Right now, that adds up to wait and see.

We might hope that reporters and Fed watchers would understand this and ignore the dots, but instead these folks generally analyze the SEP in a manner much sillier than would be accepted when dealing with uncertainty on the sports or weather desks. For example, imagine a Fed reporter who, after the December FOMC, is shifted to the sports desk for the football bowl season. We reach the half-time interview of the coach:

Reporter: What share pass plays versus run plays do you plan in the fourth quarter?

Coach: Well, that depends on what’s happening. If we’re behind, we’ll pass more. If we’re ahead we’ll run more.

Reporter: But what is your modal, or most likely, outlook for passing versus running?

Coach: [Perplexed] Well, the game is tied now, and we’ll take it one play at a time.

Reporter: [Insistently] But what is your modal, or most likely, outlook for passing versus running?

Coach: [Annoyed] Well, if I have to say, I guess my base case is that we’ll be winning in the fourth quarter, so I guess that means my modal outlook is that we’ll emphasize running over passing.

The Fed watching-sports reporter has his lede: Coach to curtail passing in fourth quarter.

Each policymaker’s dots reflect a Fed game plan under one assumed scenario; the dots collectively reflect a mish-mash of 17 different scenarios. This time, Yellen told us that the SEP is even more of a mess than we might have thought, because some policymakers chose to simply punt (ok, that’s the final football reference) on the key issue! Yellen somewhat cryptically explained that an unstated share of the policymakers elected to base their projections on an arbitrary “no change” assumption for fiscal policy until the policy picture clarifies.[1]

Notice that with the dollar and longer-term yields up significantly since the election it might be natural to mark down your forecast unless you built in some stimulus that would offset the financial market tightening.[2] Perhaps this helps explain why the central tendency for the federal funds rate in 2017 shifted down.

The uncertainty regarding Trump policy scenarios will remain prominent for a while. Assessment of likely policies and macro outcomes over the next year or two will depend on the relative likelihoods of various good and bad Trump policy scenarios: will the rise in the deficit be small, large, or nonexistent; will trade disruptions be small, large, or nonexistent; will tax cuts go mainly to the rich or poor (a distinction which is key to assessing the stimulative effect).

Right now, Fed policymakers have no reason to take a stand on such issues—as Yellen said, there is plenty of time to wait and see. Importantly, when the time comes that the Fed must make calculations about the likelihood of these scenarios, those calculations will surely remain behind the shield of the Fed’s long-standing, and politically necessary, tradition of not commenting on contentious policy from the rest of the government. We saw this in action at the press conference. Don’t expect to see the Fed announce its view of the probability, say, of a Trump trade war. Thus, in the SEP we’ll be stuck with the macro forecast implied by 17 different (but unstated) views of the most likely Trump scenario.

As for the press and Fed watchers, many will probably continue with the sort of silliness we saw after the December meeting. For example, from the FT:

Yesterday’s Fed surprise was that officials’ upward revision to their projected path for interest rates appeared to reflect some sense that the combination of Mr Trump and a Republican-controlled Congress will be able to cut taxes and ease fiscal policy. “The surprise and what the market is reacting to is that most people expected a wait-and-see stance from the [Fed] in terms of how they would consider the impact of Trumponomics in the year ahead,” says Ian Lyngen, a strategist with BMO Capital Markets.

Oops. Stick to your guns Ian, Yellen confirmed that you were right. But the dots did not reflect “wait and see” because, well, you can’t reflect “wait and see” in the choice of one single “what if?” Or consider this from the often astute Tim Duy,

What did budge was the rate forecast, the dots. The median dot shifted up 25bp; the September median forecast of 50bp of rate hikes for 2017 is now 75bp… This is important. It is almost as if the Fed is drawing a line in the sand with an increased confidence that they have the correct natural rate estimate.

Oops. They’ll tell you if something important happens to the view of the consensus. Instead, Yellen emphasized that the change was not important. Of course, it would be genuine news if anyone sensible had increased confidence in much of anything right now. The huge thing that happened since last FOMC meeting is the election, and I’m pretty sure that the election did not raise anyone’s confidence about their ability to measure the natural rate of unemployment.

Both the press and the reports of many Fed watchers were filled with this sort of nonsense. I won’t speculate much about why this might be the case, but I will note that these folks are paid to spin interesting stories. Who could avoid the temptation to hype a 17-headed monster like the SEP?

Let me be clear that I’m not claiming that those inside or outside the Fed don’t know anything about the policy future. For example, being optimistic by nature, I’ve down-weighted the various bad Trump scenarios and my most likely scenario involves short-term stimulus from fiscal/tax policy and deregulation—this leaves for my nightmares any longer-term implications of such policies. Anyone who shares this near-term, rosy Trump scenario should expect a somewhat faster pace of rate increases than before.

The point is that the dots, and particularly, the median dots (with some policymakers ignoring possible fiscal policy change) shed no light on what the consensus sees as the relative likelihood of the various good and bad Trump scenarios. And the FOMC has no special information about these questions. And if and when they assign probabilities to these scenarios, they won’t share those views with you.

Thus, until some other major economic story arrives, to predict Fed policy, you should focus on your own assessment of the relative likelihoods of various Trump policy scenarios. If you expect significant stimulative effects of Trump policy—at least in the short run—you should expect that the FOMC will raise rates as rapidly as is appropriate. I suspect that most of the FOMC could imagine three or more rate increases happening if significant stimulus takes hold. If, in contrast, you think that the net effect of the election on the economy will be minimal or negative, expect rates to rise at the very gradual pace we’ve seen recently. In this case, you should also expect longer-term yields to round trip, yet again, back nearer to where they were before the election.

As for me, at least through the remainder of the holidays, I’m sticking with the rosy Trump scenario: a robust economy is greeted by a Fed happily rising rates. But my New Year’s resolution will be to face reality. I’ll get back to you in January.

Until then, all the best for the new year to you and your families from the CFE.


1. Yellen:

… some of the participants, but not all of the participants, did incorporate some assumption of a change in fiscal policy into their projections. [back]

2. Although the rising stock market is a partial offset. [back]