– Views Differ On Low Inflation As Monetary Policy Concern
– Strong Economic, Financial Conditions Outweigh Weak Inflation
Written exclusively for InTouch Capital Markets
16th November 2017
By Steven K. Beckner
With the Federal Open Market Committee on the verge of dramatic changes in leadership and composition, minutes of the Federal Reserve policymaking body’s last meeting might seem like merely a trip down memory lane.
Nevertheless, the upcoming minutes of the October 31 – November 1 FOMC meeting could contain useful clues as to what is likely to happen at the December 12-13 meeting and beyond. My expectation is that, while the minutes will again show fissures on the Committee, they will say nothing to disabuse rate hike expectations.
We know the Nov. 1 outcome. With recently installed Vice Chairman for Supervision Randal Quarles voting for the first time, a unanimous FOMC stood pat on interest rates, keeping the federal funds rate in the 1 to 1 1/4 percent target range it had been in since the FOMC last raised the key overnight rate in June.
Meanwhile, the FOMC left balance sheet reduction on auto pilot, as designed. Since implementing its June plan at the mid-September meeting, the Fed has been shrinking its massive bond portfolio by rolling over maturing Treasury securities only to the extent they exceed $6 billion per month and by reinvesting principal payments from agency mortgage backed securities exceeding $4 billion per month. In the first quarter of next year, those caps will rise by $4 billion per month.
The FOMC’s policy statement gave every indication more modest rate hikes lie ahead, despite the fact that inflation continues to run well below its 2% target, and the minutes are likely to reconfirm that.
Chair Janet Yellen and her colleagues put storm devastation behind them, observing that “the labor market has continued to strengthen and that economic activity has been rising at a solid rate despite hurricane-related disruptions. Although the hurricanes caused a drop in payroll employment in September, the unemployment rate declined further. Household spending has been expanding at a moderate rate, and growth in business fixed investment has picked up in recent quarters.”
Once again, the FOMC was forced to acknowledge inflation “remained soft” and that both core and headline inflation “have declined this year and are running below 2%.” The statement also noted “market-based measures of inflation compensation remain low,” while “survey-based measures of longer-term inflation expectations are little changed, on balance.”
Nevertheless, while the FOMC expected year-over-year inflation to stay below 2% “in the near term,” it predicted it will “stabilize around the Committee’s 2% objective over the medium term.” As it has since June, the FOMC said it is “monitoring inflation developments closely.”
(October’s 0.1% rise in the core consumer price index, following seven consecutive monthly declines, which left the core CPI up 1.8% from a year ago, is mildly encouraging, but that’s for the next FOMC meeting to contemplate).
Not only did the FOMC say “the stance of monetary policy remains accommodative,” it strongly implied it is too much so, stating, “the Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate.”
In short, the FOMC kept pointing toward a third 2017 rate hike.
But the Nov. 1 statement camouflaged considerable differences among Committee members, although it was endorsed even by previous dissenter Neel Kashkari, president of the Minneapolis Federal Reserve Bank.
Divisions And Crosscurrents
The minutes will undoubtedly show familiar divisions among officials. On one side are those who want evidence that inflation is achieving or about to achieve the Fed’s 2% target. On the other side are those willing to essentially take it on faith that increasing labor and other resource utilization will lift inflation inexorably higher. In between is a group of officials who are concerned about low inflation but don’t want to indefinitely delay further rate “normalization.”
There have been signs of spreading skepticism of the proposition that tight labor markets ipso facto lead to wage-price pressures. We have heard more cautious voices, including to some extent Yellen. But there has been enough residual belief in the Phillips Curve to keep the Fed on track for continued “gradual” “normalization” of interest rates.
Other monetary crosscurrents are at work as well. On one hand, the FOMC’s predisposition to gradualism has been reinforced by a mounting consensus that the real equilibrium short-term interest rate and in turn the longer run, nominal funds rate have fallen significantly because the economy’s growth potential has slowed.
In the September Summary of Economic Projections (SEP), FOMC participants further reduced their estimate of the longer run “neutral” funds rate to 2.8%. That made a cumulative 145 basis point reduction in the theoretical rate at which the economy can grow without accelerating inflation in the last six years.
Yet, at the same time, stronger economic growth and the prospects of even more robust expansion if proposed tax cuts have their promised stimulative effect could cause policymakers to second-guess themselves. If fiscal stimulus does arrive, Yellen and others have conceded they will have to reassess their policy assumptions and adjust their projected rate path.
For most officials, I suspect, it’s a little premature to count on faster growth stemming from tax cuts, especially given the trouble Republicans are having reaching agreement.
As St. Louis Fed President James Bullard told me ahead of the meeting, “If better things happen (as a result of tax cuts) that would be very welcome and we would adjust to that. So there is some upside risk, but I think for planning purposes you shouldn’t be announcing to people that you’re going to be raising interest rates in the future.”
Wall Street has had to come to terms with downside as well as upside risks of tax reform. Until recently, stocks were repeatedly breaking records, partially on hopes for corporate and other tax cuts. But lately the market has had to confront the political reality that agreeing on any kind of tax overhaul won’t be quick or easy. Share prices have suffered broad setbacks as conflicting Republican tax proposals on the two sides of Capitol Hill caused disappointment and uncertainty among investors.
Just as the Fed will need more evidence inflation is headed toward target, it will need proof that fiscal stimulus will accelerate GDP growth and alter Fed assumptions about a low neutral funds rate.
It will be interesting to see how divergent viewpoints are portrayed in the minutes.
Differences Won’t Override Higher Rate Consensus
Too much should not be made of such differences, though. After all, when FOMC participants last revised their economic and rate forecasts at their September 19-20 meeting, they stayed with their projection for a third 2017 rate hike and three more in 2018, notwithstanding the dispute over below-target inflation. Since then, the economy has shown good momentum amid still favorable financial conditions.
So it’s hard to imagine there was much of a sea change at the Oct. 31-Nov. 1 meeting.
There has been less than usual Fed commentary since Nov. 1, with the main focus being on who would succeed Yellen as Fed chairman in February.
But Philadelphia Fed President Patrick Harker probably gave a pretty dependable barometer reading on mainstream Fed thinking in a Nov. 10 speech.
“(R)emoving accommodation is the right next step for a few reasons,” he said. “Monetary policy in the United States has been very accommodative for close to a decade. The economy now is more or less at full strength: There’s very little slack left in the labor market and growth has kept pace with our projections.”
Harker, who voted for the March and June rate hikes, acknowledged “inflation is still below the Fed’s target rate and is the one area that not only continues to elicit caution, it even constitutes a conundrum… I do think we have to be cautious, therefore, about how we’re measuring inflation.”
However, “with a labor market this tight, inflation is likely to reassert itself at some point,” he continued. “All of which is to say that as we near the point of full health, it makes sense to return policy to a more normal stance.”
In making monetary policy the FOMC should be “keeping our powder dry” in Harker’s view. This means getting the funds rate up from the zero lower bound and reducing the size of the balance sheet to make the
Fed’s countercyclical tools available and effective “if another crisis were to occur.”
Alluding to former Fed Chairman William McChesney Martin’s remark that a central bank’s job is to “to take away the punch bowl just as the party gets going,” Harker said, “I don’t think we’re taking away the bowl; I think we’re making sure there’s enough punch for the future.”
New Atlanta Fed President Raphael Bostic, who will be a voter next year, seemed to stake out moderate ground on Nov. 14. Predicting “more of the same” in terms of GDP growth, unemployment and inflation, he said, “I think it will be appropriate for interest rates to rise gradually over the next couple of years, as our policy position is still very accommodating rather than neutral.”
“How gradual that pace will be depends on the strength of the incoming macroeconomic data and what it implies for the economic outlook,” Bostic added.
Chicago Fed President Charles Evans, who voted for the March and June rate hikes but has since sounded more dovish, hailed “solid” GDP and job growth on Nov. 15. But he again warned “persistent factors are holding down inflation, rather than idiosyncratic transitory ones. Namely, the public’s inflation expectations appear to me to have drifted down below the FOMC’s 2 percent symmetric inflation target.”
But the same day Boston Fed President Eric Rosengren, once regarded as a dove himself, made a persuasive argument for further rate hikes.
True, at 1.6% PCE inflation is 0.4 points below target, but at 4.1% unemployment is 0.5 points below the FOMC’s estimated longer run rate, Rosengren observed. In such situations, he noted the FOMC’s Statement on Longer-Run Goals requires a “balanced approach” — “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.”
“While these so-called ‘misses’ in the mandate are of relatively similar magnitudes currently, most forecasts expect the inflation ‘miss’ to be temporary, but the unemployment ‘miss’ to be more persistent,” Rosengren went on. “While low inflation allows monetary policymakers to remove accommodation gradually, it remains the case … that a gradual increase in interest rates is the balanced approach to reaching both of the Federal Reserve’s mandates in the next several years.”
Predicting unemployment will drop below 4% and “increase pressures on inflation and asset prices,” Rosengren sees “the need to continue to gradually remove monetary policy accommodation, which is quite consistent with market expectations of another increase in December.”
It would appear the ayes have it. But we’ll have to wait until Dec. 13 to see.
The FOMC must then decide whether to follow through on past projections and raise the funds rate another notch to 1.25-1.50 percent. And it will revise its economic and funds rate projections for the next three years. The minutes of the last meeting seem unlikely to portend either forbearance on that third projected rate hike or major changes in the dot plot.
Prior article by Steven Beckner for InTouch Capital Markets: Powell To Provide Steady Hand as Next Fed Chairman
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.