– But Expect Lively Debate on Inflation Outlook
– Balance Sheet Cuts, Rate Hikes Also On Tap
– Cleveland Fed’s Mester: Could Start Cutting Balance Sheet, Hike Rates At Same Time
By Steven K. Beckner
Written exclusively for InTouch Capital Markets
24th July 2017
NB This article includes quotes from Cleveland Fed President Meter which are taken from an interview conducted by Steven Beckner on Thursday 6th July, before the start of the pre meeting blackout period.
When to start? Reducing the Federal Reserve’s massive balance sheet, that is. Before the next increase in the federal funds rate? After the next rate increase? Or, perhaps even, as Cleveland Federal Reserve Bank President Loretta Mester suggested to me recently, at the same time?
These are among the issues Fed policymakers are sure to discuss when they gather for their July 25-26 Federal Open Market Committee meeting.
Of course, there are more fundamental questions that will need to be answered before the exact choice of policy tools and timing are decided. In particular, what is going on with inflation? Why is it running stubbornly below the FOMC’s 2% target? And, taking the longer term view, how much does sub-par inflation really matter in the context of an economy near full employment, whose growth is being fueled by accommodative financial conditions?
It will take time to make a final determination on such issues. So the upcoming FOMC meeting is unlikely to yield immediate new monetary policy actions so soon after the FOMC raised rates and announced balance sheet reduction plans on June 14.
[OIS market analysis shows no chance at all being priced in for a hike in July and just 41% by year end]
But the meeting will be important all the same, as Fed Chair Janet Yellen and her colleagues grapple with the incoming economic information and try to judge whether the ever-changing and sometimes misleading data are fulfilling their forecasts.
The Fed has reason, on the whole, to be cheerful about the outlook when they look at economic and employment numbers. Growth of the U.S. gross domestic product appears to have rebounded from 1.4% in the first quarter to 2.4% in the second quarter, and prospects seem generally encouraging for growth to continue exceeding the economy’s longer run trend or potential, which the Fed now estimates at 1.8%.
With June’s stronger than expected employment report, non-farm payroll gains have averaged 180,000 per month so far this year, which as Yellen observed in her mid-year Monetary Policy Report to Congress is “well above the pace we estimate would be sufficient, on average, to provide jobs for new entrants to the labor force.”
The unemployment rate ticked up in June to 4.4% from a 16-year low 4.3%, but only because labor force participation increased a tenth to 62.8%. Broader measures of labor utilization also show much diminished slack.
The problem, as Yellen acknowledged in her recent Congressional testimony, is that wage gains remain disappointing. Average hourly earnings, which had showed signs of picking up late last year, are up just 2.5% from a year ago.
And price increases have been frustratingly modest.
As recently as February, the price index for personal consumption expenditures (PCE) stood 2.1% above a year earlier, while the core PCE was running at a 1.8% year-over-year rate. But by May, the overall and core PCE rates were down to 1.4%. The consumer price index has also softened, with the core CPI falling from a 2.2% year-over-year rate in February to 1.7% in June.
Fed policymakers have to ask themselves: has the underlying trend of prices really changed that much? The answer seems obvious. The FOMC consensus at the June 13-14 meeting, minutes show, was that the weakness in inflation is largely “transitory.”
And as Yellen testified on July 12, “It appears that the recent lower readings on inflation are partly the result of a few unusual reductions in certain categories of prices.” In an obvious reference to lower low prescription drug and cellphone prices, she added, “These reductions will hold 12-month inflation down until they drop out of the calculation.”
Revealingly, the Dallas Federal Reserve Bank’s trimmed mean price index, which has gotten increasing acceptance among economists in and out of the Federal Reserve system, has shown much less change. The index, which throws out the largest and smallest price components of the PCE in any given month, has run 1.7% year over year for the three months through May, down only a tenth from February.
Citing those numbers, Dallas Fed President Robert Kaplan said he believes that “despite recent weakness, as slack continues to be removed from the labor market, headline inflation should reach, or exceed, the Fed’s 2 percent longer-run objective in the medium term.
Nevertheless, the FOMC can scarcely ignore its “dual mandate” goal of “price stability,” which it has defined as 2% PCE inflation. Perforce, it intoned in its June 14 statement that it is “monitoring inflation developments closely.”
Subsequently, a number of Fed officials expressed caution about moving ahead with monetary “normalization,” at least with regard to the funds rate.
“I don’t see why we would not be served to allow more time to wait,” Chicago Federal Reserve Bank President Charles Evans said after voting for a hike in the funds rate target range to 1-1.25% and for a plan to shrink the Fed’s $4.5 trillion balance sheet “this year.”
Kaplan, who also voted with the majority, 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.
“I will want to assess the inflation process closely before making a determination on further adjustments to the federal funds rate in light of the recent softness in core PCE inflation…,” Fed Governor Lael Brainard chimed in. “I will want to monitor inflation developments carefully, and to move cautiously on further increases in the federal funds rate, so as to help guide inflation back up around our symmetric target.”
Such comments have caused some to jump to the conclusion that the FOMC is about to put policy on hold. But there’s a big difference between monitoring inflation and allowing temporary softness to overwhelm other reasons to continue normalization of rates from very low levels.
Stocks leaped on the perception that Yellen was signaling a slower pace of tightening because of below-target inflation when she told the House Financial Services Committee, “It’s premature to reach the judgment that we’re not on the path to 2 percent inflation over the next couple of years. We’re watching this very closely and stand ready to adjust our policy if it appears the inflation undershoot will be persistent.”
But arguably market participants put too much emphasis on the word “adjust” and too little emphasis on the word “premature.”
As Yellen clearly stated, a conclusion that the FOMC is going to forego or greatly delay a third rate hike this year is “premature.”
While there have been stronger expressions of caution from some policymakers, these are preliminary and not universally held views.
One purpose of the upcoming FOMC meeting will undoubtedly be to reach a consensus on the inflation outlook. We all know the price indices have been uncooperative in recent months, but the real issue is where they’re headed over the forecast horizon.
“Certainly we want to look at those data and get under the hood of those data a little bit, but at this point … I agree that there is a transitory phenomenon…” Mester told me when I spoke to her earlier this month.
“I’d be concerned if I saw some deterioration from those reports on the demand side, like if the reason we’re getting the disinflation pressures was because demand is falling off, but I don’t see that in the data,” Mester continued. “I think those are more reflective of supply side considerations.”
When I asked her why the FOMC should continue raising short-term interest rates and plan a balance sheet reduction that could raise long-term rates when inflation is so low, Mester responded, “The medium run outlook for inflation is that it’s gradually moving up to 2%. I don’t think a few data reports that came in on the weak side have led me to reassess that outlook.”
Mester said the FOMC will “want to look at the data and continue to reassess things,” but emphasized, “You want policy to be forward-looking. Experience in the past is that basically we’ve been able to engineer continued expansions when we’ve been preemptive in terms of moving … to take off some accommodation before we’ve reached our policy goals, because monetary policy, of course, can only affect the economy in the medium run.”
“So you want to be preemptive,” she went on. “You don’t want to wait until you hit the goals, because in the past what’s happened is we got behind. I don’t believe we’re behind the curve right now, but I do think we have to take the lessons of history which suggests we should be moving away from some of the excessive accommodation we needed during the crisis and earlier in the recovery.”
For full details of the discussion between Steven Beckner and Cleveland Fed President Mester around the timing of balance sheet reduction and rate hikes see his separate for InTouch Capital Markets published separately.
Now, it’s true that Mester tends to be more hawkish than some. But it’s worth noting that, while FOMC participants as a whole lowered their median PCE inflation projection for this year to 1.6% in the June Summary of Economic Projections, they left their projection for 2018 and 2019 unchanged at 2.0%.
The FOMC will undoubtedly also be taking a close look at inflation expectations, and there the evidence has been mixed. As the FOMC stated in June, “Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.”
To be sure, there has been a sharp decline in inflation “break-evens” — the spread between nominal and inflation-protected Treasury securities (TIPS) — in recent years.
The closely watched five-year/five year forward inflation expectation rate, which measures expected inflation in the second half of the 10-year period, fell from 281 basis points at the beginning of 2014, to 212 basis points at the beginning of 2015, to 179 basis points at the start of 2016. The spread rebounded to 210 basis points at the start of 2017, only to fall to as low as 178 basis points on June 21, but has since rebounded to 190 basis points.
But while the Fed keeps a close eye on this and other market-based gauges of inflation expectations, it does so warily, because they are known to closely track volatile oil prices.
As oil has plunged from $105 per barrel in early 2014 to barely more than $30 and back up to around $47 currently, there have been nearly commensurate swings in inflation break-evens.
Survey measures of inflation expectations, to which most Fed officials pay more attention, have tended to be more stable.
For instance, the New York Fed’s June 2017 Survey of Consumer Expectations showed that “inflation expectations fell slightly at the one-year horizon but increased noticeably at the three-year horizon, reversing to a large extent the 0.4 percentage point drop in the prior month.”
While the FOMC is sure to have a lively discussion of inflation, officials won’t be looking at wage-price behavior in isolation.
As Mester put it, “We have an economy that’s growing a bit above trend; we have inflation which I believe is gradually moving back up to 2%; we have the unemployment rate below most estimates of the natural rate of unemployment, and we have employment growing at a pace above that needed to keep the unemployment rate constant. All those things together suggest we should be continuing on this gradual path of reducing the amount of accommodation in the economy.”
As they did in June, FOMC members are also sure to take a close look at stimulative financial conditions, which include surprisingly low long-term interest rates and record stock prices.
My sense is that it would take a major reassessment of the inflation outlook for the FOMC to abstain from further rate hikes this year. Yellen’s “premature” comment suggests that such a consensus is unlikely to be reached at the July FOMC meeting. But there is sure to be a lively debate over the timing of the next rate hike and the commencement of balance sheet reduction.
The FOMC meeting is highly unlikely to result in immediate action — either to raise short-term interest rates or to start tapering securities reinvestments and put upward pressure on long-term rates.
But those will surely be hot topics of discussion around the FOMC table, and as policymakers take fresh stock of economic and financial conditions at mid-year, they may well develop contingency plans for moving forward with both facets of normalization. Their discussions could set the stage for one or the other type of action at the Sept. 19-20 FOMC meeting.
Alternatively, the FOMC could reach a consensus to delay further normalization efforts out of an excess of caution, amidst oft-stated concerns about below target inflation.
Speculation about what the FOMC will do and in what order has evolved. Once it was supposed that the FOMC would have completed its three projected federal funds rate hikes at the September meeting and that balance sheet reduction would not commence until December.
But while that remains possible, the betting has changed to favor beginning balance sheet reduction in September and delaying the third rate hike until December.
The FOMC encouraged such thinking last month when it accelerated the balance sheet normalization process. It made a major departure. For a year and a half, the FOMC had said it would prevent any balance sheet shrinkage and “help maintain accommodative financial conditions” by reinvesting proceeds from agency debt and mortgage backed securities and rolling over maturing Treasury securities at auction “until normalization of the level of the federal funds rate is well under way.”
On June 14, when it raised the funds rate for the second time this year and the fourth time since the financial crisis, the FOMC not only declared that it expects to start tapering reinvestments “this year,” it released detailed plans on how it intends to start shrinking its massive bond portfolio through steadily escalating increases in the amount of maturing securities that will be allowed to run off ($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).
The questions for financial markets are: when the FOMC will hike the funds rate again, when will it actually implement its balance sheet reduction plan and in what order?
The presumption has been that the FOMC would either do the rate hike before the start of balance sheet reduction or afterward. But believe it or not there’s another alternative: do both simultaneously.
When I interviewed Mester, she said there is nothing to prevent that since the balance sheet reduction strategy is so gradual and unlikely to have a big impact on rates.
“The main policy tool we have right now is the funds rate…,” she explained. “So when I’m thinking about policy, that’s the tool I’m thinking about calibrating so we can maintain a sustainable expansion.”
“The balance sheet, when we went in to do the various asset purchase plans, we knew that at some point the economy would recover, would be strong enough that we would have to take that accommodation out,” Mester continued. “So the plan for reducing the amount of reinvestment … is basically one that says, ‘okay let’s start bringing the balance sheet back to a more normal level and normalizing the composition of the balance sheet as well.'”
“Now that plan that we put out details of at the last FOMC meeting of course is a gradual plan,” Mester went on. “So there’s nothing in my mind that precludes us (from) initiating that AND doing something on the funds rate even at the same time.”
Perspectives on balance sheet reduction vary, and birds of a feather don’t always flock together.
It might seem hawkish to advocate an early phase-out of reinvestments, and indeed there are hawkish voices for doing so.
Kansas City Fed president Esther George wants to start shrinking the balance sheet “sooner rather than later” because of “the observed disconnect between short-term rates and long-term rates. Despite four 25-basis-point increases in the target funds rate since December of 2015, longer-term yields remain little changed.”
George fears that “if further increases in the target funds rate fail to transmit to longer-term yields, the yield curve could flatten further” and warns that “such a rate environment can distort investment decisions.”
“To the extent that reducing our asset holdings will apply some modest upward pressure to longer-term interest rates, balance sheet normalization could promote the more typical transmission of short-term interest rate changes throughout the yield curve and ensure that all components of policy accommodation are removed in a gradual manner,” she argues.
There are doves who think the Fed needs to maintain a large balance sheet to provide continued monetary accommodation on the long end of the yield curve. But there are also doves who are eager to get going on balance sheet reduction to facilitate resorting to quantitative easing again if needed to counter economic weakness.
So for now there seems to be more of a consensus for fairly early reduction of the balance sheet than there is for a third rate hike in the near term.
Prior article by Steven Beckner for InTouch Capital Markets: FOMC Minutes May Show Just How Much Of a Split There Is On Inflation
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.