Even amid all the emphasis on uncertainty, it would have been hard to miss the anxious, somewhat hawkish, tone to the descriptive narrative in the Minutes to the Federal Open Market Committee’s December meeting that were released yesterday.
But for all the speculation over the the possible effects of the incoming Trump Administration’s fiscal policy on the Fed’s rate projections, our sense is that the December meeting in fact revolved far more around a surprisingly contentious debate over the merits and risks of a “high pressure” economy, even without the assumed fiscal boost later this year and into 2018.
We drew three main points from the Minutes in how we think the December meeting discussions are laying out the Fed’s near term policy path:
*** While we were a little surprised that half the Committee, not just a few, had already included a greater fiscal impact in their forecasts and rate projections, we believe the fiscal adjustments were indeed relatively minor as Chair Janet Yellen suggested in her post-meeting press remarks. But it also suggests there could be more upward adjustments to the median rate projections in March and especially in June, as more information on the “scale, composition, and timing” of fiscal, regulatory and tax policies comes in from Capitol Hill. ***
*** Instead, the modest upward tweaks to the median of projected rate hikes were primarily driven by some Committee member concerns over “accelerated” price pressures if there is a “substantial” undershoot of the longer run unemployment rate. So while the base case path remains for a “gradual” ascent in rates, even its definition is up for debate, suggesting Chair Yellen will soon be facing a major consensus and communications challenge. And the debate over inflation risk will also elevate the importance of wage measures, beginning with tomorrow’s Non-Farm Payrolls. ***
*** But what really leapt out for us was the single sentence buried in the participant discussion section raising the issue of the Fed’s reinvestments policy. It is our sense that while the FOMC has been putting off the balance sheet question for as long as possible — with all its complications and political sensitivities — an active discussion of when and how to end reinvestments, and how it could factor into the adjustments to fiscal policies, will get underway by the middle of this year, with a roadmap to ending the reinvestments perhaps unveiled in the second half of this year. ***
Weighing the Fiscal Factor
There were three surprises for us in the December meeting Minutes. The first was that even though all the Committee participants agreed there was a heightened uncertainty over “possible changes in fiscal and other economic policies,” half the Committee members nevertheless penciled a fiscal boost to demand into their forecasts that went into the Summary of Economic Projections.
It had seemed unlikely for such an early forecast adjustment before the full scale and scope of the fiscal, regulatory, and tax policy changes under the Trump Administration and Republican-controlled Congress became more apparent. But we understand the fiscal impact on the forecasts was in fact relatively minor — for now — and indeed, the staff noted the forecasts were based on “provisional assumptions that fiscal policy would be more expansionary in the coming years.”
They also noted the presumed expansive fiscal effects would be “substantially counterbalanced” by the restraining effects of the higher dollar and bond yields. And what’s more, the slightly higher inflation assumed in the forecasts were not driven by fiscal effects, but by the higher oil prices going into this year and the base effects of the oil price fall in 2014-2016 finally washing out. So our sense is that the fiscal impact on the slight quickening in the pace of projected rate hikes in the December rate dot plot was limited.
Instead, the upgrade in the median projection for rate hikes this year to three from two, and across the remaining two years of the forecasting horizon, was in fact primarily driven by the concerns by a Committee minority over rising price pressures due to how low and for how long the unemployment rate would be running under the assumed longer run unemployment rate, or NAIRU.
Indeed, a second surprise for us was how extensive, and apparently contentious, the debate was in December over the merits and risks of a “moderate” versus “substantial” undershoot of the longer run unemployment levels.
According to the Minutes, “some” Committee participants, as well as some voting members, agreed with Chair Yellen’s base case views that as long as the FOMC continues with the gradual adjustments — which we do think a Committee majority still sees as two hikes as the most likely pace this year — there is only a “modest” risk of the below NAIRU labor market driving up inflation. And what’s more, with inflation still below the Committee’s 2% inflation objective, a “moderate” undershooting of the longer-run unemployment rate could still help return inflation to 2%.
So for the Chair and the Committee majority, the benefits to maintaining that so-defined gradual pace, even with a below NAIRU unemployment rate, still outweigh the potential costs in overshooting the inflation target — a “symmetrical” target, even though the Minutes do not explicitly say so as a reminder.
But juxtaposed against that, “several” Committee members argued the labor market may tighten even more than the base case scenario; perhaps the Labor Participation Rate stops rising or stabilizing against the secular demographic downtrend, and as jobs continue to be created, the headline unemployment rate drops further still and, presumably, wage pressures in such a tight labor market start to build, translating into price pressures that slip inflation beyond the base case forecast of no more than 2% right through 2019.
Indeed, in the full range of unemployment projections before the top and bottom three forecasts are deleted, some Committee members marked the unemployment rate as low as 4.1% by 2019, and inflation as high as 2.2%, a very rare admission of exceeding the target.
A “High Pressure” 2017
The unexpectedly contentious nature of this debate carries all the hallmarks of the debate over whether the Fed should “engineer” an overshoot of the inflation target as the optimal policy to ensure a prudent distance from being forced back to the Zero Lower Bound. For her part, while Chair Yellen has opposed an engineered overshoot of the inflation target, she would seemingly accept the relatively modest risk of “accidentally” overshooting the inflation target in keeping the pace of policy normalization gradual enough to soak up the last of slack around the edges of a tightening labor market.
To that point, although the phrase never made it into the Minutes, the debate in December seems to have been all about the “high pressure” economy scenario Chair Yellen posed as a research question in her October speech in Boston. And the fact that it met such an unexpected resistance in December would explain the rather defensive tone to Chair Yellen’s disavowal of the high pressure remarks as a mere research subject rather than a stated policy objective in the post-meeting press conference (see SGH 12/14/16, “Fed: Holding Back the Tide”).
In other words, this Committee minority is already putting a marker down raising serious policy objections over the assumption the Fed can afford to continue with a gradual pace of rate hikes — which they fear is being interpreted by the markets as meaning no more than two hikes this year. And that this debate is already entering into the policy discourse well before the presumed boost to demand — and inflation — of expansive fiscal policy in an economy already above trend and at full employment is telling.
That means two things to us going forward. First, it elevates the attention the Fed will be placing on the measures of wage pressures, the first up beng the Average Hourly Earnings and Average Weekly Hours in tomorrow’s Non-Farm Payrolls. There seems to be an expectation within most of the Fed that the AHE is likely to pop back up, perhaps to as high as 2.8% or more annualized after having been flattened a bit by calendar effects in November.
If the base case forecast bears out, however, that stronger looking wage growth is more likely than not to flatten out through the first half of this year before its underlying upward momentum begins to show itself through the rest of the year, perhaps finally piercing the 3% mark to a new higher level by next year.
But taking into account how far the inflation debate has advanced, the Committee’s close eye on inflation dynamics will make the March meeting rate decision and statement language more pivotal than we had been assuming. In effect, March may have been put in play by the December debate.
March will become even more pivotal in that by then a better sense of the legislative ambitions of the Trump Administration and the Republican-controlled Congress should start to come into a clearer view. In turn, it suggests further modest upward adjustments in the rate projections across the three year forecasting horizon could come into play in the March rate dot projections, and certainly by the June meeting.
And however low we may think the probabilities are for a rate hike in March, even the debate over one would open the door to the market more aggressively pricing in at least two more hikes this year. At minimum, it would also force a change in the statement’s “gradual” language, a point already raised by some Committee members.
So our sense of upside risks to a gradual pace of two rate hikes this year is even more firmly etched into our wary eye on the policy path this year (SGH 12/14/16, “Fed: Holding Back the Tide”).
Revisiting Reinvestment Policy
One last point we wanted to at least briefly touch on was the third surprise in the December Minutes, that “several” Committee members raised a question over the Fed’s reinvestment policies. The issue seemed to be most on the minds with a more hawkish tilt in their expectations, asking that if they turn out to be right about the need for a quickened pace of rate hikes, then that “could also have implications for the reinvestment of proceeds from maturing Treasury securities and principal payments from agency debt and mortgage-backed securities.”
The FOMC has been reluctant to even broach the subject of its reinvestment policy or the balance sheet due to its complications and political sensitivities. For one, there is no precedent from which to base the expected duration effects of a run-off of balance sheet assets on financial conditions, so it is going to be difficult to gauge how much of an equivalent effect a shrinking balance sheet would have relative to a rate hike.
An end to reinvestments would also have to first entail a decision on how and at what pace to let the assets run off. There seems to be a Committee consensus for now to taper the roll-off of balance sheet assets with a set amount each month, which might entail some asset purchases amid the maturing assets rolling off the balance sheet.
But there remain all sorts of secondary decisions, for instance, what to do with the average duration of the portfolio. And while rates remain the sole policy perogative of the Fed, balance sheet policy will invariably overlap with the Treasury’s debt management policies, as the Large-Scale Asset Purchase programs did.
But our sense is that the policy decisions on reinvestments and the balance sheet in general were being held, in some sense, in the back pocket as a policy option to tigthen financial conditions to soften any negative collateral effects of any need to quicken the pace of rate tightening. We are just a bit surprised the issue came up already in the December meeting rather than, say, over the coming spring or summer meetings.
While it is far too early to speculate with any decent sense of probabilities, a better sense of the evolution of inflation dynamics with the economy already at full employment, coupled with a clearer picture of the Trump Administration’s mix of fiscal, regulatory, and tax policies would, taken together, suggests the FOMC may start to openly discuss its balance sheet options by this summer, perhaps even earlier.
And that, in turn, could pave the way for unveiling a reset balance sheet policy on the nature of an end to its reinvestment policies in the second half of this year. But for now, we doubt the balance sheet will be shrinking before next year.