Dudley is the guy who said last year something to the effect that the Fed’s projections have an extremely wide standard error, and that people would be surprised at how wide it is. Speaking of which, we should be getting the error bands around the SEPs at the June meeting. So it’s interesting that he was as specific as he was in his interview, considering we are data-dependent. I found a lot of interesting nuggets from his short interview:
- He is still a dove. He said “The consensus among many people is that the neutral FF rate adjusted for inflation is somewhere between 0 and 1% [2-3% range with 2% inflation] …we have maybe 100-150bps of tightening ahead perhaps. But it all depends on the economy… I don’t think [we need to get there] that soon.” It’s interesting he used a sentence structure where he discusses what others are thinking and then he elaborates on what he is thinking. According to my math,
50 – 0.91 = 1.59 or [consensus FF rate] – [current FF rate] = [hikes left to consensus]
Yet he seems to think we only have 4 to 6 hikes left. His view is more dovish (about 34bps) than that of the consensus. He also said there is some slack in the labor market and that the economy is clearly not overheating.
- He is leaning towards two more hikes this year. “A couple more hikes this year seems reasonable. If the economy is a little stronger than we expect, we could do a little bit more. If it is weaker than we expect we could so a little bit less.” But it all depends on the economy! He of all people knows how data-dependent the Fed will be, so there could be a lot of variability from the projections.
- But he is not overly dovish, since he hasn’t factored in fiscal stimulus. “[I haven’t factored in fiscal stimulus] explicitly because I don’t know what it is, how big it is, or when it’s going to happen… The fact that I think fiscal policy is likely to turn somewhat stimulative over the next couple of years… this creates more upside risks to the outlook than before.” So it is very plausible for the “dove” to want 4 rate hikes in 2017 (from 3 currently), if nothing happens other than some form of reasonable stimulus gets passed.
- The balance sheet will be unwound gradually. “If you talk to people in the market, … they think that [the balance sheet normalization]is going to start some time with the Fed Funds rate between 1 and 2%. So not quite yet. It wouldn’t surprise me some time later this year or some time in 2018, … that we’ll start to gradually let securities mature rather than reinvesting them. … The balance sheet is really not our primary tool of monetary policy. Short term rates are our primary tool of monetary policy.” Since he is the head of the New York Fed (where they do all the balance sheet transactions), his voice could carry more clout on these matters. It is interesting that he again used a sentence structure where he focuses first on what others are thinking. I am inclined to read from this that he is a little less eager to unwind the balance sheet, since he could have said “some time later this year or some time in early 2018”. He mentions at one point how precise the current IOER/RR system is at targeting the effective Fed Funds rate. He seemed to delight in the fact the Fed hiked 25 and the FFER went up exactly 25bps. If the size of the balance sheet has no effect on the operation of monetary policy, is it that urgent for them to stop? So while he does mention “later this year” I tend to think he would want to put it off. This is also because from a “profit maximizing” perspective, then the Fed funds are relatively low, you want to keep buying (reinvesting) in the longer end to add to the favorable carry trade where you are receiving a higher longer term rate and paying the lower shorter term rate. The Fed has been passing some much-needed money to the Treasury since QE began. Why would you stop adding to the cash cow? This could also explain why the Fed wants to hike gradually. I will discuss this further in a future CA, as it has implications for the conduct of the ECB and BOJ as well.
- To Dudley, normalizing the balance sheet is a substitute for short term hikes. “My personal opinion… if we start to normalize the balance sheet, that’s a substitute for short term rate hikes. Because it would also work in the direction of actually tightening financial conditions. So if and when we decide to begin to normalize the balance sheet, we might actually decide at the same time to take a little pause in terms of raising short term interest rates.” This was probably the most interesting quote from Dudley. I think stopping reinvestments in lieu of a hike was something that people in the markets had considered (especially since Hatzius mentioned it a few weeks ago), but it was interesting that this was mentioned so specifically. Couldn’t conditions warrant doing both? This is what caused the rally led by the reds on Friday. However, as I mentioned in the email on Friday, the markets seem to be selectively focusing fewer hikes in the next 2 years, rather than also considering the effects of reduced buying the long end (which should steepen the curve).
I’ll discuss further curve implications in the following Trade sections.
 It seems like the former colleagues may be chatting informally.