There was plenty to weigh in the December Federal Open Market Committee meeting Minutes released this afternoon. For one, there was that generally reassuring optimism on the outlook going into this year all the bad stuff abroad notwithstanding, and a healthy looking Nonfarm Payroll this coming Friday would help to reinforce the Fed’s confidence in the sustainability of the US recovery.
But the main takeaway for us was elsewhere, in what we thought were essentially three criteria being laid out before the FOMC will feel comfortable enough in pulling the trigger to start lifting rates off the zero lower bound.
*** Our base case still lies with a June lift-off in rates that could slip to September, as it has to be said in light of the Minutes that the developments in the oil and bond markets since mid-December may be nudging more Committee members back to a late September rather than June lift-off in rates. They will certainly be more cautious and careful in their messaging in the weeks ahead, emphasizing both how gradual the tightening trajectory is likely to be and how highly accommodative policy will be through most of the long awaited normalization of rates later this year. ***
The three criteria we took from the Minutes were mostly in two different passages. First, the improvements in the labor market, slack being further reduced and the fall in the headline unemployment rate, need to continue as expected through the year and in the forecast.
And on that front, the FOMC, according to the Minutes, were reasonably upbeat lower oil prices and other drivers were keeping the recovery momentum going “more than anticipated” in 2015 and into 2016, that the boost from lower energy costs could be “quite large,” before slowing in 2016, albeit with those international risks pointing to the downside in the near term:
Many participants regarded the international situation as an important source of downside risks to domestic real activity and employment, particularly if declines in oil prices and the persistence of weak economic growth abroad had a substantial negative effect on global financial markets or if foreign policy responses were insufficient.
However, the downside risks were seen as nearly balanced by risks to the upside. Several participants, pointing to indicators of consumer and business confidence as well as to the solid record of payroll employment gains in 2014, suggested that the real economy may end up showing more momentum than anticipated, while a few others thought that the boost to domestic spending coming from lower energy prices could turn out to be quite large.
Of particular interest as well in the above passage is that rather unusual “plea” of sorts to foreign policy makers — if foreign policy responses were insufficient — and elsewhere in the Minutes to take decisive action to cut off the downside tail risk to the US recovery. Memo to the ECB: take note.
Second, the inflation trend will be even more key to the timing to lift-off, judging by the sentence that probably stood out the most in the Minutes, and which the media tended to highlight in its immediate coverage:
With lower energy prices and the stronger dollar likely to keep inflation below target for some time, it was noted that the Committee might begin normalization at a time when core inflation was near current levels, although in that circumstance participants would want to be reasonably confident that inflation will move back toward 2 percent over time.
It is a sentence loaded with meaning, and can be broken down into two developments the FOMC will need to see before it will feel comfortable in raising rates for the first time in a more than decade:
a) Inflation has to be still rising towards 2% in the forecast which, judging by the Minutes, the FOMC is indeed still expecting “over time” — a rather vague time frame offering maximum flexibility — and as long as the recovery is sustained as per criteria one;
b) Inflation needs ideally to be at least at or “near current levels,” which is a rather important insertion since both core and headline inflation by spring are expected to be quite a bit lower than their December levels.
Two out of Three Enough for Lift-off
We do still believe the FOMC is keen to get off the zero lower bound as soon as it is firmly confident on the recovery reaching a self-sustaining momentum. Most of the Fed see enough underlying strength in the economy’s domestic fundamentals to weather the drag from the higher dollar and weakened exports or an energy sector adjusting to lower oil prices.
The boost to demand from lower oil and gasoline prices will more than offset the drags on growth by the middle of this year, with the risks to the forecast to the upside by the second half of this year essentially balancing out near term risks to the forecast from abroad.
And as long as an above-trend growth remains intact, the Fed is reasonably confident that almost by definition, unemployment moving down to or through the lower end of projected longer run levels will “in time” put upward pressure on prices and thus maintain the projected upward movement in inflation back to mandate-consistent levels.
But at the same time, it seems unlikely inflation will be convincingly picking back up by summer from the downward pressure on prices through the first half of the year due to the collapse in oil prices as well as the imported dis-inflation through the stronger dollar. That will leave many FOMC members cautious in moving on rates without at least some data to bolster the upward inflation in the forecasts.
It will probably be the evidence of a stronger and more sustained looking wage growth that will tip the balance within the Committee for June or September. And it is the relatively low odds for the desired wage growth to be clearly showing up in the data by early June that is making us now lean a tad towards a more cautious September first rate hike rather than June. On the other hand, we still see almost no chance of a rate move before June.
A Likely Gradual Ascent
Ultimately, of course, for the Fed to be finally moving off the zero lower bound after six long years, the difference of a few months to lift-off is negligible in policy terms. Instead, it is clear that for most Fed officials, the pace to the upcoming tightening will be more important than its start date.
And in that sense, we were a bit surprised there was apparently little to no discussion in December over the most likely pace of tightening. Perhaps it was just too early to do so, but we do suspect Fed officials will be putting a greater importance in their upcoming messaging on the pace of the tightening trajectory, more specifically for a majority of the Committee, how gradual the ascent needs to be and is likely to be.
Indeed, firming up a consensus on the likely pace and how to message the reasons behind the likely gradual pace will be a centerpiece of the policy discussions at the FOMC’s upcoming January meeting, and perhaps making its way into the forward guidance in the March meeting statement.