When the Minutes to the September meeting of the Federal Open Market Committee are released this afternoon, the one thing the market will be most looking for is what they might suggest was behind Fed Chairman Jerome Powell’s almost casually delivered observation a week after the meeting that the Fed is “probably” a long way from neutral.
*** We expect the Minutes will indeed underscore the upward shift in the FOMC consensus towards a more hawkish near-term policy stance, reflected in the arc of Chairman Powell’s own messaging of at least a few more, gradually paced, rate hikes from here. Stronger than expected data has brought the FOMC’s previously dovish Phillips Curve faithful on board with the more hawkish policy lean, and with even more muscular economic data expected through year-end and into early next year, there is now a solid Committee consensus the near risks are to the upside. ***
*** That said, we do not believe that consensus extends beyond a continued, gradual pace of rate increases to neutral, whose level will only become evident in the meeting-to-meeting assessments through the middle of next year. It is still our sense a pause is not entirely out of the policy calculations just yet – although defining what exactly constitutes “a pause” becomes certainly trickier once every meeting is live. Even if the burden of proof is increasingly on those who argue for one, the rate decisions beyond December hike and probable hike in the spring next year will depend on the uncertain evolution in inflation dynamics. ***
Tightening Financial Conditions
The modest ratcheting up in Powell’s messaging seems to have finally gotten the market’s attention — as perhaps intended — with the sharp rise and steepening in the yield curve, which in turn rattled the stock market complacency (a little anyway) and prodded at least one CNBC viewer to complain the Fed had “gone crazy.”
But that was all after the September meeting, and we suspect the Minutes will include some further Committee discussion of the risks in the lack of much financial tightening in the accumulative rate hikes up to that point. The minutes may include more debate on the flattening of the curve and the risk of yield curve inversion, but the issue of a “conundrum” redux seems likely to fall out of the debate for now.
And on that financial conditions theme, we will also be curious whether the Minutes will include any Committee discussion of the “elevated risks of either accelerating inflation or financial imbalances,” as Fed Governor Lael Brainard recently put it.
The references to financial excesses and imbalances by so many Committee members, including the Chairman, has been hard not to notice, but where and how it factors into the policy rate path decisions remains undefined (SGH 9/20/18, “Fed: September Messaging”).
We suspect Powell shied away from extended references to financial stability risks in both the post-meeting presser and his comments the following week because the Fed has not yet reached a consensus on how to incorporate and communicate financial stability concerns when there is no mechanical rule or model to guide the policy approach, with discretionary judgment still the rule.
Grabbing the market’s attention in underscoring the high likelihood of more rate hikes on the way, against that backdrop, certainly worked to dampen the financial risk, at least for a while.
Inflation Dynamics and Trade Effects
We think the Minutes will also include an extended discussion over the evolution of inflation dynamics that, invariably, dials back again to the merits of the Phillips Curve as the key conceptual framework to forecasting the underlying trend in inflation. Powell did his part to shoot down any mechanical approach by the Fed in assuming an accelerating inflation that would be tightly linked to the tightening in the labor market for so long below its estimates of NAIRU.
Quite a large number of the Committee members, however, do still clearly see an inevitable risk to the inflation forecast if the labor market is not stabilized fairly soon through further rate increases projected to reach north of 3%.
That inflation remains so inertial is for now the only reason the rate trajectory could afford to be gradual, but if those assumptions prove to be wrong, at least the FOMC has been prudent enough to have already preemptively been lifting rates to their current levels long before inflation began its awaited ascent.
That is probably where the trade effects on inflation may also show up in the Minutes. Inflation is presumed to still be inertial, anchored by low inflation expectations and more or less tethered just above mandate-consistent levels by the projected rate path.
But there is likely to be a concern expressed in the Minutes that the trade tariffs could trigger a change in price-setting behavior with firms testing their pricing power and with consumers more willing to accept higher prices for either services or goods, whether they have anything to do with direct trade effects or not.
Those possible trade effects may well be layered into the persistent legacy of the Phillips Curve assumptions to account for differences within the FOMC on the policy path evident in the September rate dot plots.
By 2020, for instance, there is a fairly stark divergence in rate paths around the median on which only two Committee members marked their rate projections, with equal numbers below and above.
In a similar fashion, in the 2021 rate dots — Powell continues to discourage taking the forecasts or rate plots too seriously — there is even more of a dispersion with the rate dot plot looking pretty elongated, which could be expected three years out.
A Fine-Tuned Reaction Function
In any case, the main takeaway we expect from the minutes is the Fed desire in the coming months and into the turn of the year to maximize its room for maneuver to respond as flexibly as possible to the signals of the underlying trends in the data, and in which every meeting next year is live and perhaps affording the luxury of “waiting for more data” in approaching the rate decisions.
On that score, we also think the Fed’s reaction function is undergoing a bit of fine tuning under the still evolving Powell policy framework: namely, a still cautious probing for neutral — it may feature less in the policy messaging, but it will certainly still be central to the internal policy deliberations — guided not just by the data, but the decomposition of the inflation data in particular over the coming months to find evidence of the feared trade effects on inflation expectations.
In particular, we were intrigued by Chairman Powell’s assertion to the very first question in the September meeting presser that the current gradual pace of rate increases may lessen the risks of a policy error in misreading the proverbial “long and invariable lags” to monetary policy. It could mean less need for a pause at some point since, in a way, the Fed will be seeing the lagged effects of the accumulative rate hikes in real time.
But as the upward lurch in yields since the meeting also testifies, it could also mean there is far less or no need to be pre-emptive in rates pushed into restrictive territory for fear of the inflation still to come.
Despite the hawkish tilt to the Fed’s recent rhetoric, our sense remains that the Powell FOMC is still sensitive to overreaching on rates, especially if the assumption still holds the fiscal effects could be fading by the latter months of next year, just when the FOMC will be debating whether rates are indeed at neutral or not. Of course, the opposite would also be true if another dollop of fiscal stimulus as we have written may indeed be in the congressional cards (SGH 9/10/18, “US: Midterms, Trade, and a “Fiscal Accelerator”).
Powell’s FOMC, in other words, prizes rate policy flexibility above all else going forward, and if the recent, modestly more hawkish messaging helps to tighten financial conditions a bit along the way, all the better. The craziness, in that sense, is not so much at C Street as it is further down Pennsylvania Ave.