Beckner: FOMC Minutes May Show Just How Much Of a Split There Is On Inflation

– Watch For Signals On Timing of Third Rate Hike, Reinvestment Tapering

– Also Look For Level of Concern About Financial Conditions

By Steven K. Beckner

Written exclusively for InTouch Capital Markets

2nd July 2017

Just how much of a schism is there on the Federal Reserve’s policymaking Federal Open Market Committee? That is what many Fed watchers are hoping to see when the Fed releases minutes of the June 13-14 FOMC meeting on Wednesday.

That’s not all to look for, though. For example, will the minutes provide any clues as to the likely timing of the next hike in the federal funds rate? Any clues as to when the FOMC will trigger implementation of its plan for balance sheet reduction? Before or after that rate hike?

[OIS market analysis shows that a hike is only 16% priced in for Sept and 58% by year end]

And what was the level of anxiety among policymakers about asset prices and about financial conditions at large? We’ve certainly heard high-level concerns about asset prices since the meeting. And officials have been looking askance at the stubbornly low level of bond yields, with one senior Fed staffer telling me they are “confounding” the FOMC’s monetary tightening efforts.

But it’s the internal debate over inflation that has been getting most of the attention lately.

It might seem that the minutes wouldn’t have all that much to tell us this time around. After all, Fed Chair Janet Yellen gave a wide-ranging, pretty explicit press conference after the meeting, and with the policy statement we had the release of FOMC participants’ latest economic and funds rate projections along with an addendum on revised “normalization” principles.

Yellen and the FOMC made it clear they intend to continue the firming of monetary policy as they raised the funds rate another 25 basis points to a new target range of 1 to 1 1/4 percent and announced a fully evolved plan for reducing the Fed’s $4.5 trillion balance sheet sometime “this year” — a schedule of steadily diminishing reinvestments of proceeds from maturing securities.

We also know that, by maintaining a median projection of 1.4% for the funds rate at year’s end, FOMC officials continued to point toward a third rate hike this year to a target range of 1 1/4 to 1 1/2 percent. And they left largely unchanged their expectations for six more rate hikes in 2018 and 2019.

Only Minneapolis Federal Reserve Bank President Neel Kashkari dissented. No surprise there.

Speaking for the FOMC as a whole, Yellen declared, “We continue to expect that the ongoing strength of the economy will warrant gradual increases in the federal funds rate to sustain a healthy labor market and stabilize inflation around our 2 percent longer-run objective.”  What’s more, she added, “Provided that the economy evolves broadly as the Committee anticipates, we currently expect to begin implementing a balance sheet normalization program this year.”

Yellen acknowledged that inflation data had been soft for three consecutive months, but downplayed that disappointing trend as having been due to “one-off” factors that will dissipate. Tightening labor markets ensure that inflation will rise to the FOMC’s 2% target, she said.

But questions remain, which we’ll look for the minutes to answer.

Notwithstanding Yellen’s confident assertions, within days of the meeting, suggestions of greater caution about low inflation from various Fed officials seemed to lay bare a split on the Committee.

And it wasn’t just Kashkari, who has since reiterated his view that there should be “no rush” to tighten credit.

“Why are we trying to cool down the economy, when there may still be some slack in the job market, and there is still some room to run on the inflation front?” he asked. “We’re not seeing wages climb very fast, and we’re not seeing inflation. That tells me the economy is not on the verge of overheating.”

Two other voting Federal Reserve Bank presidents also voiced misgivings about subpar inflation and suggested a go-slow approach might be in order.

“We have to assure the public that we recognize the new low-inflation environment and that we are not overly conservative central bankers who see our [2%] inflation target as a ceiling,” Chicago’s Charles Evans said, adding, “I don’t see why we would not be served to allow more time to wait”.

Yellen and others are holding on to the Phillips Curve notion that falling unemployment, ipso facto, must eventually lead to wage-price pressures, but Evans, among others, has grown skeptical.

“I can’t say that the Phillips Curve isn’t going to lead to higher inflation, but I worry that it’s very flat and it’s not going to…,” Evans said. If a tightening labor market does not generate higher inflation “then it means we need even more accommodation to get inflation up.”

Ostensibly casting doubt on a third rate hike, Evans said, “It remains to be seen whether there will be two rate hikes this year, or three, or four, or exactly when we start paring back reinvestments of maturing assets.”

Dallas’s Robert Kaplan, who also voted with the majority on June 14, also seemed to express reservations about raising rates further two days later.

“In this job you make trade-off decisions; I think the fact that inflation of late has been more muted, for me, made me weigh those trade-offs much more carefully,” he said. “Before I’d be comfortable taking the next step in raising the fed funds rate, I’m going to want to see more evidence that we are making more progress” toward hitting the 2% inflation target.

Similar comments came from non-voter James Bullard, president of the St. Louis Fed.

But do such comments indicate a significant shift in Fed thinking? The minutes could be revealing in that regard.

So far, we have to be dubious whether the predominant view — that policy remains overly stimulative for an economy at or near full employment — has moved very far. That seems to be the message from the Fed leadership, despite discouraging readings on inflation.

The price index for personal consumption expenditures (PCE), the Fed’s preferred inflation gauge, ticked down for a third straight month in May to 1.4% on a core, year-over-year basis, confirming what the consumer price index had previously shown.

But so far this downtrend doesn’t seem to be ringing alarm bells for most officials. On the Monday after the meeting, New York Fed President William Dudley, downplayed such data — instead highlighting the 4.3% unemployment rate, a 16-year low.

“This is actually a pretty good place to be,” the FOMC Vice Chairman said. “We are pretty close to full employment. Inflation is a little lower than what we would like, but we think that if the labor market continues to tighten, wages will gradually pick up and with that, inflation will gradually get back to 2 percent.”

When Yellen herself weighed in the following week, she said she and her colleagues “would certainly want to avoid” a decline in inflation expectations but reiterated the need to “gradually” raise rates.

Philadelphia Fed President Patrick Harker, who has emerged as a mainstream voter, also gave a full-throated defense of Fed tightening despite downticks in the PCE and CPI.

“Will soft inflation data derail our normalization plans?” he asked, then said, “It’s a mistake to get caught up in a single decimal point, report, or even a quarter’s worth of data. The importance lies in underlying trends, and, in the case of inflation, I’ve seen the factors exerting downward pressure as temporary.”

“For the meantime, therefore, I’m sticking to my outlook that we’re on the right path,” Harker said, “but I’m adjusting my view slightly on meeting our inflation goal from the end of 2017 to the beginning of 2018.”

More importantly, Harker implied, there is “very little slack left” in the labor market. And he predicted wage gains will accelerate from 2% to 2.5-3.0%. So he “still see(s) another rate hike as appropriate for 2017.”

San Francisco Federal Reserve Bank President John Williams, a one-time “dove,” also hewed to the normalization strategy laid out before the troubling dips in inflation.

“(R)ecently, some special transitory factors have being pulling inflation down”, the former top advisor to Chair Janet Yellen said  last week. “But with some of these factors now waning and with the economy doing well, I expect we’ll reach our 2 percent goal sometime next year.”

Williams added that “the very strong labor market actually carries with it the risk of the economy exceeding its safe speed limit and overheating, which could eventually undermine the sustainability of the expansion

To change the normalization path, Cleveland Fed President Loretta Mester said June 23 she’d “have to see that there is really a sharp decline in demand… coupled with weak inflation data.”

Richmond Fed chief economist Kartik Athreya, in an exclusive interview, said there is “good reason” to think low inflation is “transitory.” With “tight” labor markets apt to push up wages and prices, he predicts inflation will “stabilize” and “return to two percent in the near future.”

Too much has probably been made of the supposed FOMC split on inflation.

That’s not to say the inflation shortfall doesn’t matter. At the margin, it could conceivably affect the timing of rate hikes and cessation of reinvestments. If low inflation proves to be more permanent than “transitory” it could tend to delay rate hikes, other things being equal.

But other things aren’t really equal, and the FOMC won’t just be watching year-over-year inflation rates, because they are sure to be dragged down by those “one-off” factors — big dips in cell phone and prescription drug prices. Rather, they’ll want to see some bounce-back in the month-to-month rates.

I promise you policymakers are not and will not be looking at inflation in isolation, as the minutes will surely confirm.

They may be proven wrong, but most Fed officials are far more focused on improving labor market conditions. Job trends matter more than the statistically challenged GDP growth rate, but officials are also encouraged that first quarter GDP growth has been revised up seven tenths to 1.4% and that second quarter GDP seems on track to grow well above 2%.

The minutes also seem likely to show that financial conditions matter a great deal to the FOMC. The counterintuitive fact is that the four rate hikes since December 2015 so far have not tightened financial conditions. Quite the contrary. Stock prices have continued to set records, and bond yields have fallen.

The 10-year Treasury note yield went as low as 2.10% the day the FOMC raised the funds rate. As this was written, it had risen above 2.2%, but that’s still far below its March high north of 2.6%. A softer dollar adds to the easing of financial conditions.

Far from seeing the decline in yields and the flattening of the yield curve as danger signals for the economy or for inflation, the tendency among many Fed officials is to see them as green lights for continued gradual tightening. Indeed there is sentiment for doing more, given that four Fed rate hikes have not pushed up yields or tightened financial conditions more generally.

Athreya, the Richmond Fed’s executive vice president and director of research, stopped short of saying low long-term interest rates justify doing more short-term rate hikes or faster balance sheet shrinkage, but did suggest the Fed’s monetary tightening has been frustrated to some extent by the failure of financial conditions to respond as “expected.”

“While changes in the Fed’s policy instruments (short-term rates) have been a force pushing long run rates up, movements in term premia, possibly arising from global forces, evidently are acting to confound their full effect,” he told me.

And there’s another issue which we may see discussed in the minutes. Kansas City Fed President Esther George and others have long justified raising rates by warning that low rates are promoting excessive risk-taking and potential asset bubbles. Now we’re hearing more such talk from the Fed leadership.

Thus, Vice Chairman Stanley Fischer said last Tuesday that “the increase in prices of risky assets in most asset markets over the past six months points to a notable uptick in risk appetites…” Yellen commented that “asset valuations are somewhat rich.”

So it will be interesting to see how the minutes portray the balance of policy considerations — low inflation versus tightening labor market conditions and easier financial conditions — going forward.

The minutes are unlikely to specify when the third rate hike will come or exactly when the tapering of reinvestments will begin, but their description of discussions about the interaction of rate hikes and balance sheet reduction could be revealing.

The unanswered questions include:

* will the FOMC make a third rate hike before or after implementation of the balance sheet reduction plan?

* will the FOMC raise rates at the same time that it curbs reinvestments?

* how will the Fed respond if the market’s reaction to balance sheet reduction is more adverse than it now hopes?

Once the FOMC starts capping reinvestments ($6 billion per month rising to $30 billion per month for maturing Treasuries; $4 billion per month rising to $20 billion per month for agency and mortgage backed securities), that process will operate “in the background” in a “boring” fashion while the FOMC gradually raises the funds rate, we’re told.

But initially, it seems unlikely the FOMC will raise the funds rate and begin balance sheet reduction at the same meeting, if only for the sake of clear policy communication and because the Fed wants to be able to distinguish the causes of whatever market reaction may ensue. (Doing both at the same time would make it more difficult to identify why the market moved as it did — because of the rate hike or because of the balance sheet action).

If financial markets do react badly to the start of balance sheet reduction, which officials don’t anticipate, the FOMC seems more likely to change its funds rate path than its reinvestment tapering plan. After all, the Fed has continually said the funds rate is its “primary” policy tool and the one most familiar to markets and the public.

But that’s not written in stone. The FOMC response would depend on the state of the economy and the degree of financial market turbulence.

The FOMC was careful to give itself flexibility in its June 14 addendum to the Policy Normalization Principles and Plans: “the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.” Yellen reinforced the point when talking to reporters.

“In addition to the way the Chair has described that the policy is going to work ‘in the background,’ the Chair has also talked about the readiness of the system to change particular aspects of it in light of conditions…,” Athreya observed. “Our Chair has indicated a willingness to stay alert to what’s evolving. So while it’s a process that ideally … looks like it should stay in the background I don’t think of that as insensitivity to conditions as they evolve.”

“I think the stated approach is fairly clear there for remaining alert to how the economy evolves and being ready to act with all the policy tools,” Athreya added.

It once seemed more likely that the FOMC would make a third rate hike at the September 19-20 meeting and delay balance sheet reduction until the December 12-13 meeting.

That’s still possible. But having moved expeditiously to announce its planned reinvestment limits in June, it now seems more likely that the FOMC will vote to implement them at the September meeting — possibly to begin in October. The third rate hike could then be made at the December meeting, depending on how inflation and other data unfold.

It’s not out of the question that the FOMC could act at the Oct. 31 – Nov. 1 meeting, but its pattern has been to move at quarterly meetings when Yellen speaks and a revised SEP is published.

Perhaps we’ll know more about the FOMC’s intentions after the minutes are released, but keep in mind that they will reflect policymakers’ views three weeks ago and are subject to change with economic and financial conditions.

Prior article by Steven Beckner for InTouch Capital Markets:  FOMC Almost Sure to Raise Funds Rate For Fourth Time On June 14th

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.