Whether the Minutes to the Federal Open Market Committee’s June meeting are taken as hawkish or dovish by the markets later this afternoon, they will likely mark the culmination of the consensus, now fraying, that Chair Janet Yellen had so successfully crafted through the first half of the year on the twin tracks of policy normalization.
*** We still believe a September rate hike is highly unlikely, barring a very improbable uptick in the data (SGH 5/22/17, “Fed: A September Pause”). There is a strong Committee minority firmly opposed to further rate hikes until there is more certainty on the inflation assumptions, and there is in fact little passion among the rest of the FOMC for a fourth rate hike since December. Indeed, one of the stronger arguments for the June hike was the policy flexibility it offered to pick and choose on the timing to a rate hike in the second half of the year, which a clear Committee majority is still penciling in for December. ***
*** The FOMC will instead focus in September on an all but certain launch of the portfolio normalization policy. Chair Yellen is likely to spend considerable time in her Capitol Hill testimony next week on the balance sheet policy as well as the rate path and the outlook. She may, if asked, highlight the Fed’s concerns over a failure by Congress to address the debt ceiling increase before September. In addition, the failure to fill senior Treasury positions is hampering the remaining Fed decision on whether to shorten up the maturities of reinvested assets or, as is current policy, to roll over into the maturities of US Treasury’s debt auctions. ***
*** The September focus on the balance sheet is seen by many FOMC members as fortunate timing because it, in effect, punts a decision into December on the deepening debate within the Committee over the nature of inflation dynamics and what it may portend in potentially reshaping the Fed’s policy orthodoxy. Indeed, Fed policy and messaging is likely to become increasingly shaped by the risk trade-offs to policy in an accelerationist inflation down the road or renewed questions over financial stability versus further embedding low or falling inflation expectations that makes a low inflation, low rate regime even more difficult to escape. ***
The Inflation Dynamic Debate
We suspect that the fairly hawkish tone to Chair Yellen’s press remarks after the June meeting will not fully reflect the range of the debate across the full FOMC that will be evident in the Minutes. Instead, we expect to see fairly lengthy discussions and debate over the dynamics of the still evolving understanding and modeling of the inflation process, the nature of global factors in particular, and above all the risks in embedding low and falling inflation expectations in continued rate increases.
A prior debate over whether the thresholds to rates increases should be based on prices data that merely conform to the forecast or must instead confirm the forecast in a clearly rising momentum is again returning to the forefront of the FOMC policy debate. It may not be resolved as easily as it has when it has been at the forefront of the policy debate (see SGH 11/20/15, “Fed: Affirming Sooner and Slower” or more recently “SGH 6/517.”Fed: Inflation and the Near Outlook”).
For the most part, there has been a firm consensus across the Committee to start rates policy normalization before actual inflation in the data. For the most part, there has been a firm consensus across the Committee since then on the merits to start rates policy normalization “sooner” than actual inflation in the data. The merits of the “sooner and slower” policy path was in allowing for that gradual pace of rate increases in nudging the policy rate to or near the assumed effective equilibrium real interest rate by the time unemployment had been pushed through its longer run levels for long enough to push up broad-based wage growth and the underlying price pressures.
Furthermore, those “pent up” upward wage pressures will finally burst into the data in a fairly rapid increases that would be foreshadowing equally persistent price pressures that would become difficult to stem or reverse without rapid rate increases to break its momentum. Better then, in order to prolong the long slow, barely above trend recovery, would be a prudent gradual pace of the rate increases to get the policy rate back to around the 2% level by around this time next year, when the up to then inertial inflation will finally be awakening from its long slumber and revealing itself in the data.
Chair Yellen gave a fairly robust defense of that base case forecast, much of which is obviously built around the conceptual framework of the Phillips Curve trade-offs between employment and inflation. To be fair, a bit too much is made of how much or how closely the Fed’s current policy path is based on the assumptions of a Phillips Curve trade-off, which by almost everyone’s reading is flattened beyond easy recognition.
But for the FOMC majority, it remains at the heart of the most basic assumptions in the how the economy operates and how inflation forms. So while the Fed may be able to look past or through the immediate impact of multiple transitory drivers, be it a plunge in oil prices, the movements in the dollar, or one-off effects of cell phone charges or medical costs, the underlying laws of supply and demand in labor costs and pricing power remain defiantly dominant over the long course of what monetary policy can influence.
The Committee consensus for that policy stance, while fairly easy to maintain through the rate increases to the current 1%-1.25% fed funds range, is now becoming increasingly harder to maintain. More significantly, it now goes deeper than just the debate over the timing to rate hikes but over the relative weights being given in the forecasting assumptions to how much inflation expectations are shaping actual, eventual inflation. One district bank staff recently ran simulations in the unemployment rate falling all the way down to 3.5% but which would only boost inflation by perhaps two tenths of a point, or still under the inflation target.
Our sense, then, is of a growing minority of Committee members questioning whether the eventual effects of a tight labor market will drive inflation higher quickly enough compared to what they fear is a more immediate, ominous downward weight on pricing power in persistently low or falling inflation expectations that are not as anchored as before, but slipping ever so slightly and slowly.
Instead, the greater risk, for them, is embedding those low expectations with further rate hikes without firmer evidence of actual inflation. Those rate increases would thus make it even more difficult to break a Japanese-like entrenched low inflation that far outweighs the risks of an accelerationist inflation in an echo of the 1970s that could require such rapid rate increases it derails the recovery or trips the financial markets into serious dislocations leading to the same end.
Unlikely Changes in Summer Messaging
What’s more, the debate is made all that much more difficult to resolve because for the most part, even those most concerned over an eventual rising inflation do not really expect it to show in the data until next year or for inflation to reach its 2% mandate-consistent levels until probably 2019. The risk that an inflation no-show in the data for such a long time might lead to holding off on rate increases is one reason several Fed officials have recently cited the risks to financial stability in a prolonged period of low rates.
We are not sure how deeply or heart felt those newly raised concerns are for many of those FOMC members, but at minimum it is a useful bridge to an eventual intended return to rates normalization, and at minimum, it reflects an acute awareness that may be a long time to keep the faith on inflation’s eventual return relative to the risk in the various measures of inflation expectations becoming unanchored and sliding south.
For instance, over the course of summer, will consumer inflation expectations rise or fall if gasoline prices take another dip? Will the broader inflation surveys the Fed puts so much more weight on compared to the market measures be dipping going into the September and remaining FOMC meetings this year?
In any case, in terms of the policy messaging over the summer, aside from a minority of the Committee voicing their concerns about inflation expectations, we suspect there is a solid Committee majority sense that there is little to be gained by downshifting to a more dovish messaging over the summer.
For one, if the data did surprise to the upside, it would be a nightmare to lurch back to a hawkish messaging to get the market back on board to price in rate hike certainties. What’s more, with the intent to push ahead with the start to the long awaited balance sheet normalization in September, what’s the rush to shift on the rates normalization stance when the debate over inflation dynamics has only begun?
There is research work underway, for instance, looking again at the evolution of the inflation process or in trying to break down the more specific channels of how inflation expectations are formed and influence pricing decisions. Another area of research is to understand why the modest increases seen to date in rising wages have not shown up at all in price pressures.
Balance Sheet Redemption
All the more reason, then, that for many if not most of the FOMC, the push to move forward on the normalization of the balance sheet at the September meeting is a Godsend.
To be sure, the start to the reduction in the size of the balance sheet does not necessarily require a rate pause, and Fed officials for the most part want to maintain the option for continued rate increases if warranted. But barring a stunning upside shock in the data between now and then, there is a clear hope across the Committee that a priority on a clean start to the balance sheet reduction provides as good a reason as any to push the rate debate into later this year.
And who knows, perhaps by December the data will provide the answer to the inflation debate by showing faster than expected wage growth or even healthier looking price pressures. There is also in some quarters a faintly whispered hope that the start to reducing the balance sheet, however small or slowly in its initial phase, could have the effect of a market re-pricing to steepen the curve somewhat and to bring back a degree of price discovery.
In the near term, there may be considerable market attention and commentary on this Friday’s Non-Farm Payroll breakdown and on the data across the summer going into Jackson Hole conference in late August. But for the most part, it will take a pretty stark and persistent divergence across the summer data to move the FOMC off its current base case for a next rate increase next December and to get the balance sheet normalization off to its start at the September meeting.
About the only thing that could complicate that September policy framework is the near inevitable political fireworks on Capitol Hill (SGH 6/30/17, “Capitol Hill: Bridge Out Ahead”). Another budget breakdown, the threats of a yet another government shutdown and, more importantly, what we suspect is the high likelihood of the vote on the federal debt ceiling only coming at the last possible moment when political leverage is at its highest — which would put the eventual debt ceiling increase at the end of September — will all be raging across the headlines before, during, and after the FOMC’s mid-month meeting.
Chair Yellen will jump at any chance to vent the Fed’s anxieties over such a scenario in her testimony next week. But on balance, we still think it more likely than not that, barring heightened market volatility, the Fed will press ahead at the September meeting with announcing the start to the balance sheet policy. The Congressional dysfunction could potentially delay the actual start in the first run-off of assets, but on that front, we will just have to wait to see whether Congress and the White House undergo an out of body experience over the August recess in suddenly becoming more coherent.