Beckner: FOMC To Reassess Economy, Policy Assumptions In Time Of Flux


Written exclusively for InTouch Capital Markets

27th October 2017

By Steven K. Beckner

The Federal Reserve’s upcoming Federal Open Market Committee meeting — next to last for the year — is unlikely to yield interest rate action, but it will give the Fed’s rapidly evolving policymaking body a chance to reassess the outlook.

It’s a peculiar time for the Fed. Just when a consensus is developing that the longer run “neutral” interest rate has dropped along with the economy’s potential growth rate, fiscal policy changes are afoot that could radically alter those assumptions.

The FOMC majority is committed to rate normalization, but at what pace? “Gradual” has been the byword, but its definition has changed since the Fed lifted left the zero lower bound in December 2015, and could change again.

The picture is clouded by uncertainty about the economy’s prospects; the inflation prognosis; how fiscal policy could boost growth, and impending changes in the FOMC itself.

Adding to its color, this will be the first FOMC meeting at which recently retired Stanley Fischer will not be in the vice chairman’s seat and the first at which newly minted Vice Chairman for Supervision Randal Quarles will participate. The three Fed governors will be outnumbered by five voting Federal Reserve Bank presidents.

It could be one of Yellen’s last meetings, pending President Trump’s decision on who will be Fed chief when her term expires Feb. 3.

Yellen’s best chance for a second four-year term may be a deadlock between conservative elements within Trump World and more establishment types in the administration. Yellen might then make a convenient scapegoat if the economy sours.

If Yellen doesn’t get the nod, Trump could go with Fed Governor Jerome Powell, a Republican former Treasury official and investment banker, who has backed Yellen policies.

A more conservative choice with impressive monetary credentials is Stanford University professor John Taylor. He would support Trump’s pro-growth agenda but would likely be independent minded — not a dependable pawn on rate setting.

More remote possibilities include former Fed Governor Kevin Warsh and Gary Cohn, Trump’s top economic advisor.

If Yellen retires, Trump can fill all but two seats on the seven-man Board of Governors with his own selections.  As of Thursday there were unconfirmed reports that Yellen has withdrawn her name from consideration and that trump has narrowed his choices to Powell and Taylor.

At any rate, the FOMC will meet in an economic climate that, notwithstanding the drag of three major storms, appears robust. Non-farm payrolls are growing well above the pace needed to absorb new entrants to the labor force and keep downward pressure on an unemployment rate already at a 16-year low 4.2%.

In financial markets, bond yields have rebounded, with the 10-year note yield back over 2.4%. But financial conditions remain remarkably easy despite four 25 basis point hikes in the federal funds rate — certainly when looking at equities. The Dow Jones Industrials recently surpassed their fourth 1,000-point milestone for the year.

The common ingredient, along with global recovery, has been solid employment and other data, including the decline in jobless claims to their lowest level since 1973, and resurgent optimism about the outlook, fueled by tax cut hopes.

One of the topics sure to come up at the meeting with greater urgency is the real possibility that major tax reform could soon get enacted. The Committee cannot presume tax rates will be slashed and that this will have substantial near-term economic impact, but it cannot help but affect discussions.

By passing budget resolutions, both houses of Congress have greased the skids for passage of major corporate and individual tax cuts, which could incentivize repatriation of $4 trillion now sheltering overseas. White House Budget Director Mick Mulvaney predicts enactment by year’s end.

The final shape tax cuts take has not been determined, and estimates of their impact on the economy (and federal deficit) diverge widely. But their mere prospect is influencing asset prices.

The fly in the ointment is that inflation continues to fall far short of the Fed’s 2% target.

Its Phillips Curve-based models project achievement of that objective as labor market “slack” diminishes. For now, though, inflation is disappointing. Although the consumer price index jumped 0.5% in September or 2.2% from a year earlier, it was driven by an upsurge in energy costs. The core CPI inched up just 0.1% and was up 1.7% year over year for the fifth straight month.

Against this variegated backdrop, the FOMC must again decide how to make monetary policy while complying with only half of its statutory “dual mandate.”

One thing is not in doubt. Shrinkage of the balance sheet will proceed “in the background” under the plan launched in September. Far less predictable is the funds rate. The FOMC will hold it steady in a 1 to 1.25% target range for now, but where it goes from there is another matter.

The debate will again be between those who think a strengthening economy, tightening job market and easy financial conditions require further withdrawal of monetary stimulus and those who want to be patient until inflation demonstrably heads toward 2%.

Some officials are willing to presume inflation will rise to target. Others want proof. And there is a more ambivalent group.

At the Sept. 19-20 meeting, minutes show the FOMC was torn when discussing “factors that could be contributing to the low readings on consumer prices this year” and “the extent to which those factors might be transitory or could prove more persistent.”

“Many participants continued to believe that the cyclical pressures associated with a tightening labor market or an economy operating above its potential were likely to show through to higher inflation over the medium term,” the minutes say. “In addition, many judged that at least part of the softening in inflation this year was the result of idiosyncratic or one-time factors, and, thus, their effects were likely to fade over time.”

But FOMC Secretary Brian Madigan’s characterization of September inflation views — that “at least some” blamed “idiosyncratic or one-time factors” — was softer than in the July minutes, which said “many participants noted that much of the recent decline in inflation had probably reflected idiosyncratic factors.”

Moreover, the latest minutes say “many participants expressed concern that the low inflation readings this year might reflect not only transitory factors, but also the influence of developments that could prove more persistent, and it was noted that some patience in removing policy accommodation while assessing trends in inflation was warranted.”

Since September, dissenting Minneapolis Fed President Neel Kashkari has reiterated “the Fed should be under no pressure to raise rates. We have time to let inflation climb back to target.” Chicago Fed President Charles Evans declared “we need to see clear signs of building wage and price pressures before taking the next step in removing accommodation.”

Dallas Fed President Robert Kaplan, who like Evans voted for the March and June rate hikes, said he “intend(s) to keep an open mind about removing accommodation in upcoming FOMC meetings.” He will “continue to assess the economy’s progress in removing labor slack, and will be looking for evidence that building cyclical forces have the prospect of offsetting structural headwinds, such that we can expect to make progress toward meeting our 2% inflation objective.”

St. Louis Federal Reserve Bank President James Bullard told me on Oct. 12 he sees no need for the FOMC to raise rates for the foreseeable future with inflation “as low as it’s been really for quite a few years” and “clearly moving in the wrong direction.”

“I think we could afford to wait and see what happens….,,” Bullard said. “We don’t need to be preemptive.”

But Kansas City Fed President Esther George warned “waiting for solid evidence that inflation will reach 2% before taking further steps to remove accommodation carries risks of overheating the economy, fostering financial instability, and perhaps putting in motion an undesirable increase in inflation.”

Boston Fed President Eric Rosengren said “failing to respond to very tight labor markets with rates remaining negative in real terms could potentially risk unnecessarily shortening the economic recovery, as rising inflation or an episode of financial instability eventually causes monetary policymakers to have to act more forcefully.”

New York Fed President William Dudley said that “with a firmer import price trend and the fading of effects from a number of temporary, idiosyncratic factors, I expect inflation will rise and stabilize around the FOMC’s 2% objective over the medium term.”

Yellen continues to project 2% inflation but with less certitude.

“My best guess is that these soft readings will not persist, and with the ongoing strengthening of labor markets, I expect inflation to move higher next year,” she said. But “our understanding of the forces that drive inflation is imperfect, and we recognize that this year’s low inflation could reflect something more persistent than is reflected in our baseline projections.”

So Yellen said the FOMC “will be paying close attention” to inflation numbers in coming months. She sounded intentionally vague about when the FOMC will hike rates again, saying only that “additional gradual rate hikes are likely to be appropriate over the next few years.”

Too much should not be made of these differences. After all, as Yellen noted, the FOMC reiterated its expectation that inflation would “stabilize around the committee’s 2% objective over the medium term.” And while FOMC participants lowered their PCE inflation projection slightly to 1.9% for 2018, they retained a 2% forecast for subsequent years.

FOMC participants continued to project a third rate hike this year, three more next year and three more in the following two years, leaving the funds rate at 2.9% by the end of 2020.

It was significant that the FOMC further reduced the longer run “neutral” funds rate from 3% to 2.8% — as officials continued to lower their estimate of the real short-term equilibrium rate or r*.

That’s another area of disagreement and flux.

San Francisco Fed President John Williams, a 2018 voter, has spoken forcefully about a falling r*. “The stars are aligned,” Yellen’s former top advisor asserts. “They all point to a new normal for interest rates…. The new normal is likely to be 2.5% (including 2% inflation), and we all need to prepare accordingly.”

Not so fast, others say.

“While underlying economic relationships can and do change, one should not be too quick to assume that relationships are unhinged as a result of expectation errors for ‘high frequency’ data,” Rosengren cautioned. “It is certainly important to adjust estimates of underlying relationships when there are large persistent variations from estimated values, but too much sensitivity to incoming data can cause monetary policy to be too easy in expansions and too slow to respond to recessions.”

A lot could happen over the next few years that could affect the “neutral” rate and whether the actual funds rate reaches, falls short of or exceeds it.

Markets project fewer rate hikes than the FOMC, but that too could change. Much may depend on the extent to which tax reform and other pro-growth measures boost productivity and GDP growth. If business investment increases demand for capital we could be looking toward a higher r* and neutral rate before long.

One knock on Yellen is that supposedly she is committed to thinking the economy cannot grow faster than 2%. That’s not entirely fair. In her Sept. 20 press conference, she indicated she hopes fiscal policy can increase productivity.

“(O)ne of the problems that the American economy suffers from, along with many other economies around the globe, is slow productivity growth, and I think it would be very desirable if a fiscal package had the potential in it to create incentives that would raise productivity growth,” she said.

Before hopes for tax cuts faded earlier this year, Yellen indicated conditionally that, if passed, they might force the FOMC to reassess the economic outlook and the funds rate path.

“Changes in fiscal policy or other economic policies could potentially affect the economic outlook,” she told reporters last December. “Of course, it is far too early to know how these policies will unfold.”

Typically, the Fed takes as given fiscal and other exigencies, but officials are aware tax reform could overturn assumptions about GDP potential, r* and more. Last December, when tax cut hopes were running high, Yellen said “some of the participants…did incorporate some assumption of a change in fiscal policy into their projections.”

We won’t get fresh projections Nov. 1. The next Summary of Economic Projections will come Dec. 12. But it will be interesting to see whether the FOMC changes its tone.

I suspect any changes regarding inflation will be relatively modest. Of greater moment may be how the FOMC assesses economic and financial conditions in light of growing evidence the economy is rebounding, record-breaking Wall Street performances and mounting momentum for tax cuts.

Financial conditions could play an important role. At the September meeting, “many participants viewed accommodative financial conditions, which had prevailed even as the Committee raised the federal funds rate, as likely to provide support for the economic expansion,” the minutes showed. And “a couple of those participants expressed concern that the persistence of highly accommodative financial conditions could, over time, pose risks to financial stability.”

To the extent asset prices keep rising, more officials could conclude that easy financial conditions reinforce the need for further rate hikes.

Although bond yields have risen considerably, they remain relatively low, and it’s unclear how much further they’ll rise. After Bullard told me balance sheet reduction is likely to raise long-term interest rates only a fourth as much as quantitative easing lowered them, Yellen reinforced the point: “Several factors suggest that the downward pressure on term premiums exerted by our securities holdings is likely to diminish only gradually as our holdings shrink.”

If that proves to be the case and if stocks continue their stratospheric climb, there will be voices on the FOMC arguing for more, not less tightening. Since Sept. 20, the Dow has risen another 1,000 points.

If the FOMC does set up a rate hike for December, fulfilling its projections of three 2017 rate hikes, that doesn’t necessarily mean it will follow through with its rate projections for the next few years. Prior to this year, we’ve seen the FOMC fall far short of its original projections — doing only one rate hike in 2015 and 2016.

But there are upside risks as well.


Prior article by Steven Beckner for InTouch Capital Markets:  Don’t Discount Yellen As Potential Nominee for Fed Chairmanship


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.