Fed: Still Betting on Mr. Phillips

Published on June 14, 2017

Even though the shock softness in inflation was hardly going to dramatically push the Federal Open Market Committee away from its policy normalization strategy today, it was still a bit jarring to hear Federal Reserve Chair Janet Yellen build so much of the Fed’s base case for continued rate hikes on that flattened Phillips Curve slowly, finally, eventually, kicking in to generate inflation.

A few observations:

** The main takeaway for us today was that the Yellen-led Fed is still betting the risk of an own-goal recession, triggered by a too-rapid ascent in rates when inflation is finally evident in the data, still outweighs the risks of embedding lower inflation and falling inflation expectations with rate hikes despite the absence of near-term inflation.

** That translates into a Fed that is sticking to at least one more rate hike this year and getting the policy rate to an effective neutral rate of at least 1.75% by next spring. We doubt the market will price accordingly, suggesting that the very core of the policy normalization strategy will be put to the test through the second half of this year.

** It will thus take a near Herculean communications offensive to push the market into pricing in a rate hike in the face of the persistent softness in inflation, however “noisy” the month to month data should be discounted; and it was curious that no mention was made of the similar global downward pressures on inflation, which can be hardly due to cell phones data charges or the lower prices for Xanax and the like.

** But while today’s rate hike and Yellen’s almost defiant, carefully phrased messaging this afternoon points to a Fed doubling down on its Phillips Curve bet, the messaging positioning seemed to us to be just as much about an FOMC carving out maximum policy flexibility going into the second half of this year when economic and political uncertainties are certain to rise.

** On that point, Chair Yellen seemed to carefully caveat the base case for the rate trajectory (and the start the paint-drying balance sheet normalization), by repeatedly noting the expected “developments” in a tightening labor market and inflation will be “monitored closely.” The unspoken implication is that should the labor market turn south, so will the rate probabilities.

And on the balance sheet:

** Chair Yellen explained the “well underway” guidance on the balance sheet run-off is not just about the level of rates but the level of the Fed’s confidence in the projected rate path as well. She also offered that it could begin “relatively soon,” which all things being equal, may still mean an announcement at the September meeting with the initial run-off as soon as October.

** The FOMC continues to impress on how quickly they have pulled the amended Principle and Plans together for the, as advertised, gradual, predictable, and (mostly) passive reduction in its balance sheet. They even inserted an explicit affirmation the Fed will resort to QE again if the economy should falter so badly it forces the policy rate back down to the effective zero bound.

** They also announced the initial cap and pre-set quarterly increases, which if started this year, would put a right-sized balance sheet at around $3 trillion by around the same time the policy rate is back up to near its longer run 3% neutral level. It would be quite a neat bit of “normalization” packaging, assuming of course, there remains a perfect world without shocks over the next few years.

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