What The Fed’s Shift From “Considerable Period” To “Patient” Means

Via Goldman Sachs’ Jan Hatzius,

1. The stellar 321,000 payroll gain, the strong ISMs, and the surge in the Philly Fed have pushed our current activity indicator (CAI) up to 4.4% for November so far, from 4.3% in October. In contrast, real GDP is on track for much slower growth this quarter, only 2.4% according to our latest estimate. The truth might lie somewhere in between; although the CAI has proven itself as a timelier and more accurate gauge than the often-erratic GDP numbers, we are not quite ready to believe yet that the economy is growing as much as 2 percentage points above trend, and would also put some weight on the weaker GDP signal in this instance. Our forward-looking view remains GDP growth of about 3%, not just in 2015 but also in 2016-2017.

2. Although it is still a close call, the strong employment numbers suggest that the FOMC will make some changes to its “considerable time” forward guidance at the December 16-17 meeting. This forecast is based on three considerations. The first is our reading of the leadership’s own expectations for the liftoff date, which still seem clustered around mid-2015 judging from NY Fed President Dudley’s speech last week. The second is our translation of the “considerable time” phrase as “no hikes for a minimum period that might be on the order of six months, subject to the recovery proceeding broadly in line with expectations.” Together with the first consideration, this suggests that the committee would want to change the language before the March meeting. And the third is that it might be awkward to make significant changes to the language at the January meeting which does not feature a press conference (at least based on the current schedule).

3. So how will the language change? In the 2003-2004 playbook, “considerable period” gave way to “patient” as a signal that the hikes were drawing closer, and it is interesting that the words “patient” or “patience” have shown up quite frequently in recent Fed speeches. The problem with a simple shift to “patience” without any qualifications on December 17 is that back in 2004 this shift occurred just 4½ months before the first hike, and some market participants might therefore take it to mean a hike before June. We doubt that the FOMC would be comfortable sending such a signal, especially given the decline in both inflation breakevens and survey inflation expectations in recent months. One simple way out for the committee would be to say explicitly that the shift to “patience” (or some similar term) reflects the ongoing progress in the recovery along the forecasted path and is not intended to convey an earlier liftoff date than the previous language.

4. Beyond the question of what will happen at the December 16-17 meeting, our own baseline forecast remains liftoff in September 2015, followed by a somewhat steeper and ultimately bigger increase in the funds rate than currently discounted in the yield curve. We have not made any changes to this forecast, because we have not changed our basic outlook for the economy. Despite the acceleration in payroll growth, the reduction in labor market slack as measured by the household survey remains on the same track as before. We still expect the broad underemployment rate U6 to fall from 11.4% now to 9% (our estimate of the full-employment level) sometime in the first half of 2016. If payroll growth stays near the levels in Friday’s report, the convergence to full employment would probably accelerate. But that is not our expectation at this point.

5. The wage picture also remains consistent with still-significant slack and thus with a strong case for a later liftoff. There was a lot of excitement on Friday about the 0.4% gain in average hourly earnings in November, but this looks somewhat misplaced. For one thing, the year-on-year rate remains at just 2.1%, roughly where it has been all year. More importantly, the strength was only visible in the “all workers” series but not in the more stable “production and nonsupervisory workers” series which enters our wage tracker alongside the employment cost index and compensation per hour. The tracker continues to grow just 2¼%, well below the 3%-4% rate that Fed Chair Janet Yellen identified as “normal” earlier this year.

6. The combination of still-significant slack and a modest amount of pass-through from commodity prices and the dollar should keep core inflation at 1½% next year. Although our forecast is ¼ point below the FOMC’s view, we think the risks to it are, if anything, tilted to the downside because of the ongoing slide in commodity prices, the likelihood that the dollar will appreciate further, and the signs that the drop in headline inflation is weighing on inflation expectations. If inflation does stay below the committee’s forecast, we would expect it to push back the liftoff date at least a little, to September or later.

7. Our longer-term expectation remains that the funds rate will return to nearly 4% nominal/2% real by late 2018, well above the 2½% nominal/½% real levels now discounted in the Eurodollar futures market. A 4% nominal/2% real rate would be consistent with long-term norms both in the United States and in other developed economies, and would in fact incorporate a small discount relative to those numbers to account for the fact that potential growth is a bit lower now. (We do not view a large discount as appropriate, partly because the link between potential growth and the neutral rate is more tenuous than widely believed.) Moreover, we read the acceleration in US growth in 2014 as preliminary evidence against the notion that the weakness in economic growth post 2007 was “secular” and in favor of our view that it was due to a lengthy but ultimately temporary hangover associated with the bursting of the housing and credit bubble. This hangover was the reason why it has taken us 5 years to get to a point in the business expansion that is typically reached in 1-2 years. But the flip side of the slow initial progress is that the expansion—and the rate hike cycle that will ultimately accompany it—still has a long way to go.

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Always the hockey-stick, always the recovery around the corner… just like in Japan… until even Goldman folded on that fallacy.