– Low Inflation a Concern But Just One Element of Fed Policymaking
Written exclusively for InTouch Capital Markets
5th October 2017
By Steven K. Beckner
Alright, it should be abundantly clear by now that stubbornly low inflation is a concern at the Federal Reserve.
But that’s not the whole story. Forthcoming minutes of the Sept. 19-20 Federal Open Market Committee meeting should help us form a more complete picture of Fed policymakers’ state of mind.
Worry and frustration at the failure of prices to rise anywhere close to the Fed’s 2 percent target have grown to the point that Chair Janet Yellen went so far as to call it “a mystery” when talking to reporters following last month’s FOMC meeting.
When she elaborated in a speech to the National Association for Business Economics six days later, she seemed to open the door to a reassessment of the inflation outlook and, in turn, the path for the federal funds rates.
The FOMC minutes are sure to confirm that concerns about low inflation have mounted and perhaps spread among Fed policymakers. But it’s not as if inflation is the only thing the FOMC looks at in setting interest rates. Arguably, there has been an inordinate focus on that one element of policymaking.
So what else will the minutes tell us? What is the overall economic and financial picture? What are the other considerations driving monetary policy? What will it take for the FOMC to reevaluate the total outlook and change its assumptions about the appropriate policy stance needed to achieve its desire outcome of “maximum employment” and “price stability.”
For now, the minutes are unlikely to hint at an impending alteration of those policy assumptions. For one thing, that is not their purpose. They are supposed to be a faithful reflection of the discussions that took place three weeks earlier — not a signaling mechanism.
And those conversations around the FOMC table, as the minutes will undoubtedly show, led to a consensus that, at least for the time being, the Fed needs to keep withdrawing monetary stimulus at pretty much the same pace that was envisioned in June and before.
The odds of a Dec. 13 rate hike are fairly high, and it seems doubtful that things will change enough by then to keep the FOMC on hold. Next year is another matter.
One need only look at FOMC participants’ revised Summary of Economic Projections. Despite the fact that inflation is running six tenths of a percentage point below target, neither their inflation nor their funds rate projections changed significantly last month.
As Yellen put it, FOMC participants’ latest inflation projections were only “slightly softer” and their funds rate projections were “essentially unchanged” from the June SEP.
The September median projection for PCE inflation is 1.9 percent for 2018, down just a tenth from June, and 2.0 percent in 2019, the same as in June. The “dot plot” still has the funds rate at a median 1.4 percent at the end of 2017, implying a third rate hike before the end of this year. It still has the funds rate at 2.1 percent at the end of next year, again implying three rate hikes in 2018.
The only difference from June is that FOMC participants now see the funds rate reaching 2.9 percent at the end of 2020 instead of the end of 2019. That would be a tenth of a point above a downwardly revised 2.8 percent longer run “neutral” rate.
Since the FOMC’s longer run inflation projection hasn’t changed, the further downgrading of the neutral rate presumably comes totally from the “real” component, or r*.
Now, there is no question that inflation continues to defy Fed forecasts. The PCE (the price index for personal consumption expenditures) was up 1.4 percent from a year ago in August, compared to 2.1 percent in February. The core PCE was up just 1.3 percent.
The Dallas Federal Reserve Bank’s Trimmed Mean PCE index, which excludes the most extreme upward and downward monthly price movements, has shown less deceleration, but even that index has been trending lower lately. The trimmed mean’s year-over-year rate of increase has gone from 1.8 percent early this year to 1.7 percent as recently as June to 1.6 percent in August.
The inflation shortfall has a vocal minority of Fed officials up in arms and arguing for delaying, if not halting further rate hikes.
Minneapolis Federal Reserve Bank President Neel Kashkari, who voted against the March and June rate hikes, leads the way in asserting that the Fed should keep the funds rate in a 1 to 1 1/4 percent range until the inflation goal has been reached. According to him, warnings that the economy could overheat and cause an inflationary break-out if the Fed doesn’t keep firming rates are mere “ghost stories.”
Kashkari is not alone. Governor Lael Brainard, who voted for the earlier rate hikes, now argues, “we should be cautious about tightening policy further until we are confident inflation is on track to achieve our target.”
Chicago Fed President Charles Evans, who also voted to raise the funds rate in June, now says he wants to “see clear signs of building wage and price pressures before taking the next step in removing accommodation.”
“Maintaining policy accommodation until we are more demonstrably on a sustainable path to 2 percent is key for reaching that objective — and for maintaining the credibility of our price stability goal,” Evans argues.
Dallas Fed chief Robert Kaplan, who joined Brainard and Evans in voting for the earlier rate hikes, says he is “open” to a December rate hike but first wants the FOMC to “get a grip” on why inflation is so far below target.
And there are others cautionary voices. Interestingly, none of those who oppose or want to go slower on rate hikes want to desist from shrinking the Fed’s $4.5 trillion balance sheet. The minutes are likely to show virtual unanimity in support of implementing the FOMC’s June plan for capping securities reinvestments.
And the minutes will likely show a consensus for resorting first to adjusting the funds rate path if needed to counter unexpected economic weakness. As the Fed has said many times, the funds rate is its “primary tool.”
Yellen said it would take “material deterioration” in the economy to change the balance sheet adjustment plan, which calls for the Fed to initially reinvest (or roll over) $10 billion less securities per month and ultimately $50 billion less, starting in October next year.
The Fed leadership is by no means ignoring the FOMC minority’s worries about stubbornly low inflation. Yellen acknowledged their concerns amply in her Sept. 20 press conference and even more forthrightly in a Sept. 26 speech.
“Although we judge that inflation will most likely stabilize around 2 percent over the next few years, the odds that it could turn out to be noticeably different are considerable…,” she told the NABE.
The FOMC’s consensus forecast is that inflation will rise to 2 percent “over the medium term” as moderate economic growth tightens labor markets and as “transitory” factors drop out over time, but Yellen conceded, “some key assumptions underlying the baseline outlook could be wrong in ways that imply that inflation will remain low for longer than currently projected.”
Yellen went on to cite three areas of “considerable uncertainty” about inflation.
“My colleagues and I may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with our inflation objective, or even the fundamental forces driving inflation,” she said. “In interpreting incoming data, we will need to stay alert to these possibilities and, in light of incoming information, adjust our views about inflation, the overall economy, and the stance of monetary policy best suited to promoting maximum employment and price stability.”
Elaborating, Yellen said “labor market conditions may not be as tight as they appear to be, and thus they may exert less upward pressure on inflation than anticipated.”
At 4.4 percent, the unemployment rate is already two tenths below the FOMC’s estimated longer run unemployment rate, but maybe that “full employment” rate is even lower, she suggested. If so that would allow the Fed to hold rates lower longer to wring out more labor market slack.
The FOMC has been assuming that long-run inflation expectations are pretty well “anchored,” but Yellen mused that expectations may have “slipped a bit” and “may not be consistent with the FOMC’s 2 percent goal.”
Yellen also allowed for the possibility that “the conventional framework for understanding inflation dynamics could be mis-specified in some fundamental way.” For example, she said, maybe the Fed’s model has not taken sufficient account of how increased globalization and online shopping have impacted prices.
If such forces have put downward pressure on inflation in a lasting way, she said the Fed might have to reassess its outlook in ways that “would naturally result in a policy path that is somewhat easier than that now anticipated.”
Given the increased uncertainty, “we will need to carefully monitor the incoming data and, as warranted, adjust our assessments of the outlook and the appropriate stance of monetary policy,” she added.
That might sound like a marked rhetorical shift. At first glance Yellen might seem to have flirted with joining the ranks of the disinflation Cassandra.
But if you look at everything she and others have said, you find that the thinking at the top about inflation hasn’t changed all that much, except perhaps prospectively, provisionally.
It’s probably fair to say that the FOMC majority has become more open-minded, somewhat, but their base case really has not changed as yet. Yellen reaffirmed that “the FOMC continues to anticipate that, with gradual adjustments in the stance of monetary policy, inflation will rise and stabilize at around 2 percent over the medium term.”
She added, “standard empirical analyses support the FOMC’s outlook that, with gradual adjustments in monetary policy, inflation will stabilize at around the FOMC’s 2 percent objective over the next few years, accompanied by some further strengthening in labor market conditions.”
But that’s not all. It’s also important to recognize that the Fed has other fish to fry — other policy variables.
Chief among those, of course, are the pace of real GDP growth and the level of resource utilization, but there are other considerations as well.
The Fed also has to weigh upside risks from fiscal policy. Hiring, spending and capital investment could conceivably leap if the Trump administration succeeds in cutting corporate and individual tax rates and repatriating the mountain of cash now languishing offshore.
Increasing evidence of synchronized global growth also play a part in encouraging the FOMC to keep firming policy.
Financial conditions figure even more importantly into the Fed’s calculations. So far Fed tightening has not translated into tighter overall financial conditions. Despite four funds rate hikes, stocks have continued to hit record highs.
Bond yields have also failed to respond as one might have expected. European and Japanese quantitative easing, among other factors, may have something to do with that. But whatever the reason, the 10-year Treasury note yield remains surprisingly low. As this was written, it had rebounded from its 2.06 percent low of early September to 2.33 percent, but that is down from 2.61 percent in mid-March.
It remains to be seen how much the unwinding of the Fed’s Q.E. affects long rates. Not a lot of impact is expected.
There is a strong strain of thought in policy circles that easy financial conditions give the Fed a green light to do more tightening, not less. The lower long rates stay, the more the Fed might have to raise short rates.
Then too, as always, the Fed has to be mindful of those infamous “long and variable lags” with which monetary policy takes effect.
“Because changes in interest rates influence economic activity and inflation with a substantial lag, the FOMC sets monetary policy with an eye to its effects on the outlook for the economy,” Yellen said.
So, although Yellen said inflation uncertainties “strengthen the case for a gradual pace of adjustments,” she went on to warn “we should also be wary of moving too gradually…”
“(W)ithout further modest increases in the federal funds rate over time, there is a risk that the labor market could eventually become overheated, potentially creating an inflationary problem down the road that might be difficult to overcome without triggering a recession,” she continued.
“Persistently easy monetary policy might also eventually lead to increased leverage and other developments, with adverse implications for financial stability,” she added.
And there’s another aspect of prudential policymaking — the Fed’s need to give itself leeway to take countercyclical actions. One reason why the FOMC is normalizing the funds rate, even as it shrinks the balance sheet, is to give itself room to cut the rate in the event of a downturn and, if possible, avoid resorting to asset purchases again. It has a ways to go to give itself the kind of cushion it would like.
Prior article by Steven Beckner for InTouch Capital Markets: FOMC to Hold Funds Rate Steady, Launch Balance Sheet Reduction
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.