Fed: The December Minutes

Published on January 6, 2016

This afternoon’s release of the Minutes to the Federal Open Market Committee’s December meeting will no doubt be closely scrutinized mostly for what they may indicate on the likely pace of the policy path and the probabilities for a second rate hike in March.

*** Prior to the December meeting, we leaned toward an April second rate hike and three rate hikes in total for the year, but warned of the risks for a March hike despite continued skepticism by dovish markets pricing two or even fewer hikes in 2016. With the December meeting mapping out a base case for four rate hikes this year, we suspect the Minutes will indicate the burden of proof will be on those arguing against a March second rate hike. Indeed, if the data in the coming months is more or less in line with the central tendency forecast, the FOMC will raise rates a second time at its mid-March meeting. ***

That said, the Committee’s caution against moving too quickly ahead of what a majority believe is a very slowly rising effective equilibrium real interest rate means, we think, the odds are still twice as high for three hikes than the prospect of five hikes on the other sides of the base case path.

Confidence in the Outlook

Despite the December statement’s carefully crafted balance to give near equal time to the dovish caution about a premature rate hike, we think the Minutes may also read somewhat hawkish in the confidence in the outlook that is likely to be threaded through the Committee’s December discussions.

Such an upbeat take on growth next year may seem sorely out of line against the backdrop three weeks later of the current renewed doubts over China, heightened geopolitical risks, or the hit to US manufacturing sector. But judging by the slew of remarks by Fed officials on the sidelines of the American Economic Association conference in San Francisco this week, the Fed’s optimism looks to be firmly built around continued consumer spending and a still robust service sector that will more than offset the slowing trade side.

And as much as the Fed is so much more optimistic than the market on the growth outlook — the median of the Summary of Economic Projections does feel a tad optimistic at 2.4% for the year — the Fed is even more optimistic that core inflation will be moving more quickly towards mandate consistent levels, reaching at least 1.6% by year-end.

The difference between the central bank’s projections and the market’s gloominess on inflation — and by extension, the pace of rate increases – is likely to come across in the Minutes, specifically in the way in which a majority of the Committee will invariably reaffirm their faith the downward pressure on prices due to the strong dollar and weak oil prices should be steadily falling out of the data this year. That alone should be enough to give the Fed the “cover,” if that is the right word, for rate increases.

Importantly, the dollar does not have to weaken or oil prices to rise in order to have a base effect on inflation, both only need to stabilize at current levels. Once stripped out of the data in successive months through the year, the more fundamental underlying price pressures will become more apparent, which the Fed believes is more or less around 1.6%-1.7%.

Low Inflation Bar

Equally, we expect the Minutes will indicate a fairly low bar to a second rate hike, lower in any case than current market expectations. Crucially, the majority of the voting Committee members will not necessarily need to see firm indications of higher core inflation prints before the second rate hike, but only signs that inflation was “conforming” to the forecast of a steady upward rise through the year to around 1.6% by year-end.

The statement was indeed carefully phrased to affirm its rate decisions will be based on the “actual and expected progress” towards its inflation mandate, and we think the Minutes will reflect the greater weight being put on the latter over the former in the progress towards the inflation mandate.

And we recall that Chair Janet Yellen pushed back against too high a hurdle to raising rates this year, demurring that there was no “simple formula” to how the FOMC will take inflation’s performance into account when weighing a rate hike.

It will also be interesting to see how much the issue of financial stability factored into the policy debate over the rate path in December. We suspect that it will indeed come up in the Minutes, and that it may, on the margin, add to a hawkish hue to the Minutes.

But what should temper any excessively hawkish reaction to the Minutes is a solid consensus across the FOMC that the central bank will still be providing plenty of monetary accommodation during the initial phases of policy normalization. That should, in turn, be taken as a signal of just how quick the FOMC, hawks and doves alike, will be to pause on or even reverse further rate hikes if there is any sense that growth and the underlying drivers to higher prices are under threat.

That perhaps, as much as anything else, should be a prominent takeaway from the Minutes later today.

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