– December Rate Hike More In Doubt But Still Possible
Written exclusively for InTouch Capital Markets
14th September 2017
By Steven K. Beckner
We’re coming up on a momentous Federal Open Market Committee meeting, and like many, I’m looking for a split decision from the Federal Reserve’s policymaking body, which is united on the need to get on with balance sheet reduction, but divided on interest rate normalization.
I say “momentous” because the moment has seemingly arrived when the FOMC will finally start whittling down the massive securities holdings built up through three rounds of large-scale asset purchases designed to counter the financial crisis and ensuing recession.
When the FOMC said, in its July 26 policy statement, that it would likely start undoing its quantitative easing “relatively soon” it created in the minds of Fed watchers worldwide the virtual certainty that it would launch its previously announced plan to scale back securities reinvestments at the upcoming meeting. Fed officials have said nothing to disabuse that expectation.
Much less certain is the timing of the next federal funds rate hike. In its June Summary of Economic Projections, when it raised the funds rate a second time this year and a fourth time since December 2015, the FOMC reaffirmed projections for three 2017 rate hikes. Most Fed officials have continued to talk in terms of a third rate hike at some point, but with less enthusiasm.
We’ll see if the revised “dots,” to be released with the policy statement, reaffirm the June funds rate projections. Chair Janet Yellen’s comments to reporters will also bear watching.
The timing of the next step toward funds rate neutrality has become increasingly uncertain. Support for a December move has dissipated, as have market expectations.
Since the July 25-26 meeting, not only has Federal Reserve Bank of Minneapolis President Neel Kashkari continued to emphatically oppose further rate hikes, but two Federal Reserve Bank chiefs who voted for the second rate hike in June, have sounded less eager to back a third.
Dallas Fed President Robert Kaplan has said he wants to see “more evidence that we’re making progress on reaching our inflation objective” and so is “willing to be patient.” Chicago Fed President Charles Evans also left plenty of doubt about his willingness to back a December rate hike: “If you thought that inflation was weaker and we needed more accommodation you could decide to put that off until later.”
Fed Governor Lael Brainard voted for the June rate hike as well, but in a recent speech she took much more of a go-slow approach, indicating she would be reluctant to do so again until inflation rises to 2% — something she suggested could take a good while.
“(W)e should assess inflation developments closely before making a determination on further adjustments to the federal funds rate,” she said.
“Once balance sheet normalization is under way, I will be looking closely at the evolution of inflation before making a determination about further adjustments to the federal funds rate,” Brainard went on. “We have been falling short of our inflation objective not just in the past year, but over a longer period as well…. (W)e should be cautious about tightening policy further until we are confident inflation is on track to achieve our target.”
Some still sound more hawkish. For instance, Cleveland Fed President Loretta Mester hasn’t really backed away from what she told me in July — that a third rate hike this year is needed.
Citing “sound” economic fundamentals and insisting low inflation is temporary, she said last month, “We can’t wait until the goals are fully met because monetary policy affects the economy with a lag. We need to remain focused on the medium-run outlook, and risks around the outlook, assessing what incoming economic reconnaissance implies about the outlook and risks.”
“If economic conditions evolve as anticipated, I believe further removal of accommodation via gradual increases in the fed funds rate will be needed….” Mester continued, adding that “a gradual removal of accommodation helps avoid a build-up of risks to macroeconomic stability that could arise if the economy is allowed to overheat, as well as risks to financial stability if interest rates remain too low and encourage investors to take on excessively risky investments in a search for yield.”
But others who had seemed like dependable supporters of a third rate hike have sounded more ambivalent lately. New York Federal Reserve Bank President William Dudley, when asked in mid-August whether he favors a third rate hike, replied, “it depends on how the economic forecast evolves,” but “if it evolves in line with my expectations, I would expect — I would be in favor of doing another rate hike later this year.”
More recently, though, Dudley hedged. “On one hand, the economy is growing above trend,” he said. “That implies that we need to continue to remove accommodation. On the other hand, inflation is below our target, further below our target than we anticipated, and we also have very easy financial conditions.”
“I think it’s too soon to judge exactly the timing of when the next rate hike might occur,” Dudley continued. “But I think the path is clear that of short-term rates are going to move gradually higher over time.”
Too much should not be made of such comments. The FOMC would shock the world if it were to raise the funds rate this time, but it’s too soon to preclude a December rate hike, which would take the funds rate to a target range of 1.25% to 1.5%.
While subpar inflation might militate against a third hike, there are other reasons to think the FOMC might move in December, most notably the accelerated pace at which the economy has been growing and creating jobs in a climate of accommodative financial conditions.
Now that the federal debt limit is out of the way (for the time being), some commentators are focusing on how back-to-back hurricanes will affect the economy and monetary policy, betting it will keep the FOMC on hold through year-end. Don’t be so sure.
Aside from their devastating human impact, Hurricanes Harvey and Irma did take an incalculable toll on the economy. Even before Irma hit Florida, estimates of Harvey’s cost in Texas and Louisiana ranged upward from $100 billion. When all is said and done, the cost could be two or three times that much, and the hurricane season isn’t over yet.
The storms destroyed homes, closed businesses, hurt employment and drove up prices. A third of U.S. oil refining and half of petrochemical output was shut down. A key gasoline pipeline supplying much of the East Coast was also put out of commission temporarily.
But Fed officials are looking beyond the short-term and expect the economy to bounce back. Calling the destruction “transitory,” Dudley said, “The long-run effect of these disasters unfortunately is it actually lifts economic activity because you have to rebuild all the things that have been damaged by the storms.”
So while third quarter GDP growth is sure to be stunted, perhaps by a full percentage point, the Fed expects it to roar back. If that becomes apparent by the December meeting, a demonstration of the economy’s resilience could reinforce the case for a rate hike.
The debt limit will become an issue again when the deal to suspend it expires on Dec. 8, but that’s five days before the FOMC makes its rate decision, and another extension is highly probable.
Then too, don’t rule out President Trump making headway on his pro-growth agenda. Former House Speaker Newt Gingrich sees a real chance of major tax reform by Thanksgiving. Treasury Secretary Steve Mnuchin advocates making tax cuts retroactive to Jan. 1.
Besides, delaying further rate normalization beyond December would go against everything the Fed leadership has been saying all year. Inaction may not undermine the FOMC’s credibility, but it would raise questions: Is the economy on a sustainable growth path or not? Is it at full employment or not? Does high resource utilization lead to wage-price pressures or not?
There’s something to be said for “consistency.” As Mester observes, staying on a gradual path of rate hikes, despite GDP and inflation fluctuations “removes some ambiguity, and it underscores the fact that we set monetary policy systematically, with a focus on the medium-run outlook and risks around the outlook and their implications for our policy goals.”
And what about the dollar, which has fallen more than 9% this year to a two-and-a-half-year low? Certainly dollar depreciation is good for net exports and GDP growth. But at what point does it become, if not inflationary, then a threat to financial stability and confidence?
One of the factors the FOMC always says it assesses in setting the funds rate is “readings on financial and international developments.” Certainly a plunging dollar falls into that category.
So does the behavior of asset prices. Record stock valuations and the decline in bond yields have eased financial conditions, and that could be another reason to boost short-term interest rates.
In saying “it is still appropriate to continue to remove monetary policy accommodation gradually” on Sept. 7, Dudley said “this judgment is supported by the fact that financial conditions have eased, rather than tightened, even as the Fed has raised its short-term interest rate target range by 75 basis points since last December.”
Noting “equity prices have risen, credit spreads have narrowed modestly, longer-term interest rates have declined, and the dollar has weakened,” Dudley observed, “On balance, these movements have been large relative to the upward drift in short-term interest rates…”
“(I)f financial conditions ease even as we are removing monetary policy accommodation, this may have implications for further policy adjustments,,” he went on. “All else equal, an easing of financial conditions may warrant a somewhat steeper policy rate path.”
Some think the resignation of Vice Chairman Stanley Fischer, effective “on or around October 13,” will make it harder to raise the funds rate on Dec. 13. Perhaps, but I wouldn’t make too much of that either. If there is a good case to be made, considering not just inflation but the full constellation of economic and financial data, Yellen should be able to build a consensus to move then.
It’s also well to keep in mind that, if it raises rates again in December, the FOMC will only have caught up, partially, with past projections. Remember that at the start of 2015 and 2016, the FOMC anticipated four rate hikes, but ended up doing only one due to untoward global economic and financial developments.
For now, we wait. But there’s no more waiting for balance sheet reduction. It is all but certain the FOMC will go ahead with implementation of the plan announced on June 14 — a progressive scaling back of securities reinvestments.
Three years after ending QE3, the FOMC is almost sure to announce that at some early date, probably early October, it will start to trim its $4.2 trillion bond portfolio.
Since October 2014, the Fed has prevented any balance sheet shrinkage by reinvesting proceeds from maturing securities, thereby keeping downward pressure on bond yields. That’s about to come to an end. The Fed will soon limit those reinvestments, and the limits will steadily rise over the next two years, gradually reducing the Fed bond holdings (and bank reserves).
Under the June plan, the Fed will begin by reinvesting payments of principal only to the extent they exceed $6 billion for Treasury securities and $4 billion for agency and agency MBS debt. Those caps will escalate at three-month intervals until they reach $30 billion per month for Treasuries and $20 billion per month for agencies and agency MBS.
Yet to be determined is the balance sheet’s ultimate size.
The FOMC has said it “anticipates that the caps will remain in place once they reach their respective maximums so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.”
The eventual size will depend on what policy implementation framework the FOMC chooses. The existing “floor” system of using payments of interest on excess reserves and reverse repurchase agreements to undergird the funds rate would require a large amount of reserves. Returning to the old “corridor” system of pegging the funds rate through open market operations would require scarce reserves and has fewer adherents.
Almost no one thinks the $4.5 trillion balance sheet will return to the pre-crisis level of $900 billion or that reserves will shrink from more than $2 trillion to their 2007 level of about $11 billion. Just the growth of currency outstanding to over $1.5 trillion will limit shrinkage.
But nearly everyone agrees the levels need to decrease substantially. Fed officials usually say the balance sheet will eventually need to be at least $2.4 trillion.
Meanwhile, the composition of the FOMC continues to change. Fischer’s resignation leaves the normally seven-person Board of Governors with just three members. The four vacancies gives Trump a chance to put his stamp on the central bank at a crucial time. His nominee for the new Board position of vice chairman for supervision, Randall Quarles, has not been confirmed by the Senate. The Richmond Fed has yet to replace Jeffrey Lacker as president.
Trump has given mixed signals whether he will keep Yellen when her term expires in February. Unconfirmed reports have Trump angry at his top economic advisor, Democrat Gary Cohn, putting him out of the running to succeed Yellen.
All very interesting to watch, but what does it mean for future policy? Difficult to say, but it’s premature to assume a reconstituted FOMC will make a big difference for the path of rates, the size of the balance sheet or, for that matter, how policy is made. The Fed seems unlikely to get very far away from the discretionary approach to policymaking, although greater use of non-binding rules as guidelines is certainly possible.
Prior article by Steven Beckner for InTouch Capital Markets: FOMC Minutes to Show Split on Rates, Consensus on Balance Sheet
Steven Beckner is a veteran financial journalist with four decades of experience of reporting on the Federal Reserve. Mr Beckner is the author of Back From The Brink: The Greenspan Years (Wiley, 1997) and can also be heard speaking regularly on National Public Radio.