Fed: A Mighty Debate

Published on October 12, 2016

Key Takeaways

The September Minutes later today will highlight the FOMC “close call” debate over where the greater risk was in the timing to a rate move before year-end.

Despite three dissents, the Committee majority concluded the lesser risk was in waiting a bit longer, for the benefit of further labor market tightening.

But the overall tone of the Minutes is still likely to read hawkish, pointing to a high likelihood of a December rate hike.

October 12, 2016

The Minutes to the Federal Open Market Committee’s September meeting due for release later this afternoon will provide more texture and context to what Chair Janet Yellen described in her post-meeting press conference as a “rich, deep, and serious, intellectual” debate. “We struggled mightily,” she added, “with trying to understand one another’s point of view.”

*** That “mighty” debate was not over the relatively small differences in the forecast or the merits of policy normalization itself, but where the greater risk was in the timing to a rate move before year-end: lifting rates too soon and potentially derailing a still fragile recovery and the desired rise in inflation, or waiting too long and risking “imbalances” that could force rapid rate hikes, triggering potential market dislocations and a shortened recovery. ***

*** Three dissenters notwithstanding, the FOMC decided there wasn’t an inflation-driven urgency to a September move and, importantly, there was a low-cost, high benefit to waiting in further labor market gains in an economy that had more “running room” due to still inertial price pressures. There was likewise value seen in a confirmation of expectations, and in a longer “runway” to the rate move, giving markets more time to prepare for modestly higher US rates. ***

*** The Minutes, then, are likely to read relatively hawkish, underscoring the Committee’s lean to a rate hike before year-end, while affirming a majority view the lesser risk, and greater benefit, would be a December rate hike over a September move or no move at all. Barring an unlikely downshift in the economy or an equally low probability downside election shock, we still think a rate hike at the FOMC’s December meeting is very likely (SGH 9/13/16, “The December Fallback”). ***

A “Close Call”

Vice Chair Stan Fischer described the September decision to pass on a rate move as a “close call,” which is an echo of the same dynamic in September last year when there was an equally close call decision to pass on the initial rates lift-off.

But probably the most important aspect of the debate that will run through the Minutes is that it was over when, not if, rates should be increased. The consensus behind the policy normalization strategy, of a gradual pace in raising rates to a presumed equilibrium neutral rate, however much it has been lowered or is likely to persist at such low levels, remains firmly intact.

What’s more, there has been a consensus for a second rate hike in that policy normalization process in place since summer. And the global risks that hung over the FOMC in the summer were dissipating by the time of the September meeting, while fairly decent if hardly strong data continued to support a rate move.

Against that backdrop of a consensus lean to a rate move, the dovish arguments that are likely to be seen in the discussion section of the Minutes will look familiar to skeptical markets: where is the urgency to move in September, and isn’t there merit in waiting until there is at least clearer evidence inflation is indeed moving towards or even passing the 2% mark — indeed an overshoot should be tolerated if not welcomed — all of which is to say a cautious December move in light of the risk management considerations when still barely off the Zero Lower Bound is warranted.

The Minutes are sure to include the counter arguments of a handful of members who will have fretted that yet another delay in acting on that consensus to lift rates would be inviting inflation risks in an economy getting “too hot” or in the financial instability risks of rates kept too low for too long. Policy, after all, operates with a lag, one of the old workhorse arguments of a hawkish frame of mind.

Boston Fed President Eric Rosengren made an interesting, more nuanced point that may show up in the Minutes, that the risk was not financial instability on the near horizon per se, but in the build up of significant imbalances due to an overshoot of the employment mandate. That overshoot, under some degree of a Phillips Curve trade-off, could translate into the need for quickened rate hikes so severe in their impact they end up shortening rather than extending the recovery.

His argument for a rate move is, in effect, the “sooner and slower” cornerstone to the policy normalization strategy that Chair Yellen herself had so laboriously laid out in building the consensus for last December’s rates lift-off.

Above all, Rosengren’s argument is about protecting a gradual pace to the slow removal of policy accommodation. The prize is in safely “probing” for just where the longer run unemployment level and equilibrium real interest rate lies, without overshooting and risking a slowing or stalled, even reversed recovery after all these years at the Zero Lower Bound. It is a cautious balancing act we suspect is shared by Chair Yellen herself.

Crafting the Compromise

Against that sense of caution, the latter section of the Minutes summing up the members discussion is likely to show how a compromise consensus was crafted around another prized outcome of the Yellen-led FOMC: that it would be worth setting aside the rate move “for the time being” to ensure a bit more in labor market tightening. That was becoming especially evident in a modestly rising participation rate.

Indeed, that the discouraged and longer run unemployed could be pulled back into the labor force if the economy is allowed to run hot enough for long enough amid a still inertial inflation is a long held expectation in Chair Yellen’s slack-based forecasting assumptions. Demographics is supposed to be driving the participation rate down, so any stabilization in that trend, much less a rise, however slight, would signal a much sought repair to the structural damage to the labor market in recent years.

The cost in any inflation risk in this case would be worth the value in seeing the data confirm the expectations for that highly prized broadening of the labor force. And thus the 7-3 vote to draft the hawkishly toned statement, with the rather explicit language the “case is strengthening” for a rate increase, albeit softened with the added clause the FOMC would wait “for the time being” — but which in itself denotes a wait that would not be for all that long.

In some sense, it is a bit surprising that Rosengren, or Cleveland Fed President Loretta Mester, still dissented when the statement was so “hawked up.” But on the other hand, it would not be all that surprising if Yellen did not quietly sympathize with the dissents since they still serve to bolster the case for a likely rate move in December.

Barring a “new risk development” or the economy drifting away from its “current course,” we suspect Yellen is among those who will also argue against so much patience that policy normalization gets further delayed. And the rate hike, when it comes, is likely to carry no dissents, as did the rates lift-off last December.

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