What will the Fed do? Dec. 2016 edition

Like most folks who focus on such things, I expect a 25 basis point increase in the federal funds rate target range at the December FOMC meeting. Since mid-August, I’ve said that under the Fed’s consistent MO, if the economy did not break strongly in either way, we’d get one rate rise this year—most likely in December. The macro data have not broken strongly either way, and while the financial market data have changed markedly since the election, they are not signaling a faltering economy. Thus, a rate increase is likely upon us.

If this is right, then the main news coming out of the meeting will be what the FOMC says about the future. This moment is a lovely illustration, in my view, of several of the issues raised in the paper I prepared for the recent CFE/Hutchins/Brookings Fedspeak event. Here is how I see these issues playing out.

We do not yet have clear, post-election data on inflation or real activity that suggest any significant change due to the election. But the labor market gains have continued, taking up more of any remaining slack. Thus, ignoring the election, there is not much news that would warrant changing the characterization of future policy. In light of the lack of major change in macro fundamentals, and in light of the current circus atmosphere surrounding all kinds of policy, the FOMC is likely to lean even more than usual toward minimal changes in its characterization of likely policy. It would be silly to inject needless material into the already weird situation. Thus, a wait and see stance seems most likely.

Is it really prudent for the Fed to largely ignore the election and the big financial market moves? As I’ve been arguing, financial market moves like this almost never lead to a fundamental change in the stance of policy unless and until macroeconomic indicators support what the financial market data may be signaling. As Bob Barbera and I note in a related post today, the recent market moves look remarkably like a limp version of what we saw in the taper tantrum. Based on these financial market moves alone, there is no more reason to significantly raise the pace of tightening than there was during the tantrum.

So what besides an acknowledgement of recent progress and “wait and see” might the FOMC attempt to communicate? The modal, or most likely, outcome for the economy has probably shifted in the perspective of most analysts. A Clinton win, amid gridlock, was the pre-election consensus, and we now have Trump, with the GOP in control of both houses. This is sensibly leading many to project significant fiscal stimulus and to mark up growth and/or inflation projections.

But in my view, more important than any change in the modal outlook is the fact that the range of likely scenarios—and the range of plausible tail risks—may have increased markedly. This poses two problems for FOMC communication.

First, even if the FOMC had a unified view, effective communication about uncertainty in peculiar circumstances borders on impossible. And the FOMC must represent 17 views of uncertainty. The FOMC will probably find it difficult to do better than the drug companies—this drug has been associated with a heightened risk of [insert list of hideous maladies], in rare cases resulting in death. For the consensus of the FOMC right now, the analogous message amounts to some version of “lots of good and/or bad stuff might happen, we’ll react as appropriate.”

Hawkish folks in the public and on the FOMC may well be disturbed by a message of “lots of uncertainty; wait and see.” They may well amplify their cries of “behind the curve” and “genie out of the bottle.” As Chair Yellen emphasized in her mid-November testimony, the consensus of the FOMC knows that inflation is highly unlikely to shift rapidly from persistently too low to out of control, and that the FOMC can safely stick to something like the current characterization of policy until things change more dramatically.

Nonetheless, because communication on behalf of the FOMC must be crafted to cover the full range of views on the committee, satisfying those concerned about curves and genies will likely require some messaging. This may well take the form of the FOMC reminding the public of its ongoing and steadfast intention to respond resolutely to any clear signs that inflation may move persistently above 2 percent.

In today’s super charged atmosphere some analysts may well mistake an FOMC reaffirmation of its readiness to battle inflation as a hawkish turn by the consensus. I don’t think such conclusions will be warranted. As I argued in the Fedspeak paper, statements intended to assuage concerns of one wing of the committee are often misinterpreted as reflecting a fundamental shift in the views of the consensus.

Similarly, the FOMC’s Survey of Economic Projections released today will be ripe material for misinterpretation. As noted in the Fedspeak paper, there is never much reason to expect consensus policy to square with the median view embedded in the SEP. And given the wide range of possible policy and real economy scenarios before us today, the median dot will be even less meaningful than usual this time.

Each forecast is based on the individual forecaster’s view of the most likely outcome. Right now, the forecasts will involve 17 different views of the most likely Trump policies and their effects. But we’ll only see the macro outcomes in the SEP and not the assumed fiscal policies. Further, if we took all 17 views of the most likely Trump policies, the FOMC participants might acknowledge that all 17 are roughly equally likely. The SEP process forces participants to pick a most likely view, and highlights this view, but the participants may not believe that their own most likely is much more likely than anybody else’s.

We should probably be glad that the consensus decisionmaking on the FOMC will not be driven by the median monetary policy response to a bunch of largely arbitrary assignments of most likely Trump policies. Instead, the FOMC will probably pick a stance that doesn’t rely too much on any one view being correct, and my guess is that wait and see, at least for a time, is the natural outcome.

So what should you expect for policy going forward?

My main point is that your expectation should depend very little on what you think that the FOMC is thinking and very much on your view of Trump policies and their macro effects.

If you expect that we will see clear signs of inflation and/or growth picking up, you should expect that the FOMC will raise rates as rapidly as is appropriate. Any sense that the FOMC is committed to low rates and a slow pace of increase independent of the economic backdrop is wrong. If, however, 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.

Don’t focus on the Fed. As James Carville regularly reminded the other Clinton on the campaign trail, it’s the economy, stupid.