There are a few takeaways we believe worth highlighting from the Minutes released yesterday for the Federal Open Market Committee’s March meeting.
The first is mostly about clarifying communications and the high art of avoiding mixed messaging in the still evolving forward policy guidance. The second is how the unexpected persistence in low inflation has pushed its way into the forefront of the policy debate.
*** First, about those dots: The Minutes made clear the first rate hike and year-end fed fund rate projections were not a more hawkish take on rate hikes being brought forward. For some Committee members, or rather their staff, their individual dot plot simply reflected a still dovish timing and trajectory, dots naturally edging up a bit as the labor market improved and with 2014 looking better than 2013. That said, the FOMC did fear it might be “misconstrued” (duh) and gave Chair Yellen the go ahead to do her best to downplay their importance relative to the statement. You live, you learn. ***
*** More importantly, and less appreciated by markets, is the degree to which the unexpected persistence in low inflation is coming to dominate the policy debate. An influential number of Committee members are making the case this low inflation persistence, global in nature, calls for an even more dovish messaging affirming the willingness to overshoot the inflation target if necessary. There is, however, an equally vocal bloc of members less unnerved by inflation no better than 1.5%, which they believe is more likely to move sideways until the recovery is more fully underway. ***
*** That divide over inflation dynamics is likely to dominate the policy debate over the next few meetings. Depending on the clarity in the data, the low inflation concerns could underpin a consensus to further bolster dovish guidance as soon as the June meeting. But even the barest wisp of an uptick in the inflation measures before then could just as easily stall or derail moves in that direction. ***
Much Needed Wage Growth
The new year began for the vast majority of FOMC members with promising growth forecasts for 2014 that would, almost by definition, pull inflation up with it towards the forecast near-2%. Instead, the winter-whipped first quarter saw dampened demand and lackluster growth, derailing any prospect for the upward pressures on prices.
Indeed, inflation was supposed to rise last year, but it failed to do so even as growth picked up and unemployment was clearly falling. March marked nearly two years of the Fed undershooting its 2% inflation mandate.
It is in fact the inability to fully understand the inflation dynamic that raises the level of concern as much as the numbers that keep coming in well below expectations; to what extent has inflation behavior and the linkage between inflation and unemployment been altered by the prolonged period of low interest rates being pressed up against the zero lower bound?
Beyond that, there is also a lingering anxiety that even if growth does pick up as expected, there is nevertheless “something afoot” in its persistence, and it is equally hard not to notice the global nature of falling inflation in Europe, even China, not to mention Japan’s two decade struggle to lift its inflation rate.
For many FOMC members, the obvious question is just where exactly the upward pressure on prices is likely to come from over the coming months and quarters? It seems unlikely to be through commodity prices or imported prices, and demand, while picking up, is hardly a barn-burner.
Instead, for many Committee members, it may have to come, and needs to come, through higher wage growth that in time eventually pushes inflation back to healthier levels. Wage growth has been running at a paltry 2% or so for some time. Low wage growth is closely correlated to low inflation, so any signs of a steady rise in wages will be taken as a positive indication of not only a more broadly-based demand growth and recovery, but a more likely gradual rise in inflation.
A recent uptick in wages was negligible and hardly a siren call for higher rates to ward off wage-driven inflation. For most FOMC members, wage growth can nearly double its current pace without any upward pressure on inflation. For all the debate over structural versus cyclical unemployment five years into a limp recovery, the most influential core of the FOMC still sees considerable slack in the labor market that means little risk of an upward push on price pressures any time soon.
The upward wage pressure on inflation, while a healthy development, may take a while, and thus, in the near term, the concern turns more to the risks in low inflation that has persisted despite the gains in employment that has helped to drive down the headline unemployment rate.
Indeed, it is noteworthy that going back to when then-Vice Chair Yellen first laid out a very aggressive optimal control policy path that entailed a trade-off between faster employment growth for potentially higher (temporary) inflation later, actual inflation has since fallen, not risen.
Debate over the Willingness to Overshoot
Against that backdrop, a good number of the Committee are pressing for stronger language in the upcoming statements to bolster the highly dovish forward policy guidance. For them, the cost in reversing falling inflation that turns into a deflationary spiral is far higher than the cost of being wrong and inflation instead rising, especially coming off such low levels.
Thus to ensure that inflation does indeed rise back towards the forecast 2%, some Committee members argue it is only natural to convey in the formality of the statement that the FOMC would be willing to risk an overshoot of the 2% inflation target if that is what it takes to get inflation back up to a more healthy level and safely away from deflation risk.
That, in this way of thinking, would be the next evolution in the forward guidance of the formal statement to bolster March’s inclusion of the sentence that the longer run neutral interest rate is assumed to be running “below normal” or under 4%. It would be a descriptive phrasing rather than going back to a quantitative definition of the overshoot — that train had already left the station by the time of the March 4 video conference call.
On the other hand, other members ceded ground on the dovish trajectory but were determined to keep any references to the willingness to overshoot the 2% inflation target out of the statement, at least for now. For them, an inflation rate that has “temporarily” dropped to 1% is less of a concern since it will inevitably be rising from here as growth steadily improves.
And, in any case, they are just not as unnerved by a 1.5% inflation rate. The 2% inflation target is more a less a ceiling, to the consternation of the more dovish who see the target far more symmetrically.
That split went a long way to shaping the phrasing of the guidance in the March meeting statement. On the one hand, it was a major step in qualitative guidance that replaced the Numerical Thresholds to have inserted into the formal statement the sentence that the longer run neutral interest rate is assumed to be “below normal.”
That in turn, points to what is likely to be a very gradual rate trajectory once the tightening is underway. Most Fed officials believe the trajectory is the more important driver for anticipating borrowing costs in the real economy than the exact timing of the lift-off, and were thus willing to give ground on the time frame to the lift-off potentially coming, however low the odds, as soon as late spring to the middle of 2015.
But on the other hand, those resisting such a dovish guidance resisted the overshoot language, in effect giving way on the below normal guidance and its implications for the trajectory (“we will see when the day comes”). They also got the insertion into the prepared remarks for the press conference that policy operates with a lag, so keep that in mind as highly accommodative policy of the last few years inevitably gives way to higher inflation.
June and the Dots as a Survey, not Guidance
That March statement, for all its balance going into its consensus, is likely to serve as the foundation for the Fed’s forward policy guidance over the next few meetings. For now, its centerpiece is the below normal longer run neutral interest rate to anchor the intended dovish messaging on rates.
Any further fine tuning will depend on how the data plays out through the year, in particular, whether the first quarter was merely repressed demand giving way to a spring snap back in the second quarter, and with it, inflation pulled back up off its 1% or less floor. By how much will determine the intensity of the debate in April and especially the June FOMC meeting.
And besides the actual inflation prints, the behavior of inflation expectations will likewise be closely watched, for if there looks to be any slippage, it is likely to prompt that further bolstering of the dovish forward guidance.
And, of course, June also brings up the increasingly infamous dot plot of the first year rate hike and year-end fed funds rate projections in the accompanying quarterly Summary of Economic Projections.
As the Minutes made clear, the FOMC essentially acknowledged that the dot plot, released as the same time as the statement, can be more of a hassle than they are worth (see SGH 3/19/14, “Fed: Believe What You Read, Not What You See”). We suspect Chair Yellen is soon going to go to some length to better frame how the dots fit into the context of the policy debate.
It is not that they are not a valuable insight into the preparations and assumptions, but they are not much more than a survey of individual views going into the meeting, essentially background material, and never designed to be pushed to the forefront of the guidance, which is the voted statement. And contrary to what be assumed, each Committee member only knows the identity of his or her dots, so that makes it rather hard to somehow steer or manage the dots by the end of the meeting to align with the voted-on guidance of the statement.
That said, it is curious why the low inflation concerns never really seemed to make its way into the dot plot, though again, who knows since the dot plot is not linked to the 13 individual staff forecasts and underlying assumptions. Indeed it may point to the willingness to “wait and see” on the developments on the inflation front, but which may still leave room for movement in the dot plot come June. For now, the market is essentially back to pricing rates on the December dots, as though March never happened.