Written exclusively for InTouch Capital Markets
2nd January 2018
By Steven K. Beckner
As the new year gets underway for the Federal Reserve and those of us who follow it we get an early retrospective on the Fed’s final act of 2017 this week from minutes of the December 12-13 Federal Open Market Committee meeting.
With this having been Chair Janet Yellen’s next to last meeting and major changes in FOMC composition coming soon, some might consider it a meaningless set of minutes. But I don’t think that would be fair.
In raising the federal funds rate a third time of the year to a 1.25 to 1.50% range Dec. 13th on a seven to two vote the policymaking FOMC fulfilled expectations and its own projections. But it was not easy as shown by the divided vote.
Chicago Federal Reserve Bank President Charles Evans said after the meeting, “the decision was a close one.” The minutes will no doubt tell us why.
The fact inflation was well below the FOMC’s target was undoubtedly a big issue at the December meeting.
Evans had voted for the March and June rate hikes, but joined Minnesota Fed President Neel Kashkari in opposing last month’s move. Explaining his dissent, he said, “Real activity in the U.S. is on a solid footing, which by itself would support a further adjustment in policy. Inflation, however, is too low and has been so for quite some time.”
“I am concerned that persistent factors are holding down inflation, rather than idiosyncratic transitory ones,” Evans continued. “Namely, the public’s inflation expectations appear to me to have drifted down below the FOMC’s 2% symmetric inflation target. And I am concerned that too many observers have the impression that our 2% objective is a ceiling that we do not wish inflation to breach, as opposed to the symmetric objective that it really is; that is, we would like to see the odds of inflation running modestly below 2% equal the odds of it running modestly above over the long run.”
Taking the same position Kashkari took throughout 2017, Evans, said “leaving the target range at 1 to 1 1/4% at the current time would have better supported a general pickup in inflation expectations and increased the likelihood that inflation will rise to 2 percent along a path that is consistent with a symmetric inflation objective.”
And he said “such a pause in the policy normalization process also would have better allowed the Committee time to assess the progress of incoming inflation data.”
If low inflation is “transitory,” as Yellen and the FOMC majority maintain, then “waiting a while longer before raising rates would have given us a chance to see whether or not that was true,” Evans argued.
But with unemployment also below the Fed’s estimate of the long-run (“full employment”) unemployment rate, most policymakers were less reactive and more forecast-oriented, trusting the Phillips Curve trade-off still has enough validity to justify removing more monetary accommodation after a six-month lapse since the June rate increase.
The majority opted for the “balanced approach” the FOMC enunciated in its January 2012 Statement on Longer-Run Goals and Monetary Policy Strategy.
“In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee’s assessments of its maximum level,” the statement said.
“These objectives are generally complementary,” the statement goes on. “However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.”
Dallas Fed President Robert Kaplan, who joined the majority in approving the December rate hike despite having previously expressed the same reservations about subpar inflation as Evans and Kashkari, invoked that statement in a late November speech that foreshadowed his vote.
“In assessing progress in reaching our dual mandate, I am increasingly cognizant of the risks posed by potential economic and financial imbalances,” he said. “Such imbalances, if allowed to build, have the potential to, at some point, threaten the sustainability of the expansion and the attainment of our dual-mandate objectives.”
To Kaplan a “balanced approach” means that “even though we are not meeting our inflation objective, the size of the expected full employment overshoot is growing and should be taken into account in assessing appropriate monetary policy actions.”
Kaplan had grown more confident inflation will rise because “cyclical forces are building, which should increasingly offset the structural forces of technology-enabled disruption and, to a lesser extent, globalization.”
“Taking all these factors into account, and from a risk management point of view, I believe it will likely be appropriate, in the near future, to take the next step in the process of removing monetary accommodation,” Kaplan concluded.
Inflation was only one issue facing the FOMC. It also could not have been easy to pull together economic forecasts and interest rate projections for 2018, 2019 and beyond at a time of such fiscal flux.
Not long after the FOMC met, President Trump signed into law a $1.5 trillion tax reform package along the lines it had expected. Centered on a 14-point reduction in the corporate tax rate, it also contained other business-friendly provisions designed to encourage capital investment, as well as a doubling of the standard tax deduction for individuals.
Estimates of the law’s impact vary, and no one knows for sure, but even the Congressional Joint Committee on Taxation projects a 0.8 point boost to growth. The administration predicts more.
The minutes should make interesting reading to see how the FOMC came to grips with the prospective macroeconomic challenges ahead.
We will hopefully find out to what extent officials saw tax reform boosting aggregate demand and straining resources versus increasing business investment and productivity. Presumably they expect both. In any case, not an easy set of circumstances in which to make policy.
The 16 FOMC participants were understandably tentative in their outlook. They did elevate their GDP growth projection, though not a great deal, from 2.1% to 2.5% for 2018, while lowering their unemployment rate projection from 4.1% to 3.9%. But they foresaw growth receding to 2.1% in 2019 and 2.0% in 2020.
The officials left unchanged their median funds rate projections for 2018 and 2019 — three rate hikes this year to 2.1%; two next year to 2.7%. Not until 2020 did they envision a modestly faster pace of rate hikes with the funds rate projected to reach 3.1% instead of the 2.9% foreseen in September.
That projected 2020 rate hike would put the actual funds rate 30 basis points above the longer run “neutral” rate, which was lowered to 2.8% in September and kept there in December.
Knowing massive tax cuts were about to be enacted one might think the FOMC would have projected more growth and more rate hikes, and the “dot plot” shows that some officials did.
On the whole, though, while FOMC participants were somewhat more optimistic, they were not as upbeat as some private forecasters or Republicans in Congress and the White House.
Plainly, most policymakers weren’t prepared to totally believe the economy is about to undergo a lasting upshift in its growth trajectory. And they remained worried about inflation’s persistent undershoot from the 2% target.
What’s more, in the absence of any real evidence of “overheating,” most were prepared to let the economy run hot for a while to draw more “discouraged” workers and the like into the labor force. The minutes will presumably validate that supposition.
We know FOMC participants did take the tax changes into account, because Yellen acknowledged as much in her final press conference. But she emphasized they did so amid “considerable uncertainty.”
Explaining the ostensible discrepancy between stronger growth prospects and modest escalation of monetary tightening to reporters, Yellen pointed to upward revisions to GDP and downward revisions to unemployment and noted, “you see only modest changes, slight revisions to the path for the fed funds rate.”
“You might think, well, shouldn’t I see more?” Yellen continued. “Well, okay, growth is a little stronger. The unemployment rate runs a little bit lower, that would perhaps push in the direction of slightly tighter monetary policy, but …counterbalancing that is that inflation has run lower than we expect, and, you know, it could take a longer period of a very strong labor market in order to achieve the inflation objective.”
It will be interesting to learn more about policymakers’ rationale and how the committee divided on these and other issues as we read the minutes.
There could be other potential points of interests in the minutes:
* Whither the neutral funds rate? From early 2012 through 2017, the FOMC had cut its estimate of the long run funds rate a cumulative 145 basis points. That has had an important influence on the setting of the actual funds rate and on balance sheet policy. Yellen and others have continued to say the neutral rate remains “quite low” but expect it to move up over the next few years.
Well, what do they think now with increases in productivity and GDP potential looming? Are we on the verge of some upward revisions of the neutral rate estimate from 2.8%?
* What about labor compensation, which has lagged for so long? Will this be the year wages and in turn prices finally perk up and inflation reaches the 2% target? It could well be. Certainly that’s what FOMC participants are hoping for.
Be careful what you wish for Messrs. Evans and Kashkari. They contend it would be just fine for inflation to exceed target for a while after years of falling short. But history suggests that once inflation gets going and starts getting built into expectations in a climate of high resource utilization it can tend to get out of control and become costly to correct.
As Kaplan puts it, “if we wait too long to see actual evidence of inflation, we may get behind the curve and have to subsequently raise rates more rapidly. This type of rapid rate rise has the potential to increase the risk of recession.”
* How much concern about asset prices registered in the FOMC’s discussions?
It was one hell of a year on Wall Street. The stock market overcame disappointments and uncertainties to sustain a record-setting gains. It didn’t hurt that the Fed raised rates only gradually from very low levels and projected relatively modest rates ahead. As the economy gained steam following a weak first quarter and unemployment hit a 17-year low, confidence grew among households, firms and investors. The Dow passed five 1000-point milestones and came within 124 points of 25,000.
Yellen called stock values “elevated,” but one suspects there is more concern among policymakers than she suggested. No one has said the market is in for the kind of correction that could devastate the economy and the financial system. But the minutes could reflect some wariness about further climbs.
Certainly asset prices have a bearing on monetary thinking, if only through their wealth effects on spending. One prominent school of thought holds that to the extent soaring asset prices loosen financial conditions they justify additional Fed tightening.
* Then there’s the yield curve — a source of consternation for many financial professionals and some Fed officials. Just how broad the concern is among policymakers might be shown by the minutes.
As the Fed raised funds rate 75 basis points in 2017, other short-term rates followed them up. But longer term rates moved little. Indeed, the 10-year Treasury note yield, to which many mortgage rates are tied, ended the year slightly below where it started at 2.40%. Rising short-term rates and unchanged long rates flattened the yield curve. If the Fed hikes rate three times as projected in 2018, St. Louis Fed President James Bullard, among others, has warned an “inverted yield curve” could bring recession.
Yellen told reporters after the December meeting “this is something that we discussed and have looked at,” but she largely disputed fears about an inverted yield curve.
“The yield curve has flattened some as we have raised short rates,” she conceded. “Mainly, the flattening yield curve mainly reflects higher short-term rates. The yield curve is not currently inverted, and I would say that the current slope is well within its historical range.”
Yellen also acknowledged “there is a strong correlation historically between yield curve inversions and recessions,” but she emphasized that “correlation is not causation, and I think that there are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed.”
“One reason for that is that long term interest rates generally embody two factors,” she elaborated. “One is the expected average value of short rates over say ten years, and the second piece of it is a so-called term premium that often reflects things like inflation risk. Typically, the term premium historically has been positive. So when the yield curve has inverted historically, it meant that short-term rates were well above average expected short rates over the longer run. So with the positive term premium, that’s what it means.”
“And typically that means that monetary policy is restrictive, sometimes quite restrictive, and some of those recessions were situations in which the Fed was consciously tightening monetary policy because inflation was high and trying to slow the economy,” Yellen continued.
“Well, right now the term premium is estimated to be quite low, close to zero, and that means that structurally, and this can be true going forward, that the yield curve is likely to be flatter than it’s been in the past,” she went on. “And so it could more easily invert if the Fed were to even move to a slightly restrictive policy stance you could see an inversion with a zero term premium. So, I think the fact the term premium is so low and the yield curve is generally flatter is an important factor to consider.”
Yellen added that “it’s also important to realize that market participants are not expressing heightened concern about the decline of the term premium, and when asked directly about the odds of recession, they see it as low, and I would concur with that judgment.”
Her view is shared by others.
A contrary concern is that long rates could rise sharply due to faster economic growth and increased demand for capital — hurting stocks as well as the housing industry.
It’s a lot for a soon-to-be Jerome Powell-led Fed to brood over in the year ahead.
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.