Fed minutes show caution

Posted on August 18th, 2016

FOMC minutes still express concern over downside risks, even though the immediate Brexit turmoil risks have diminished. The core decision makers expressed patience and we do not expect serious consideration of a rate hike until December.  Not discussed in these minutes and still hanging over the market are the recent views expressed by Dudley and Williams that neutral rates are low, suggesting the Fed should proceed more cautiously with rate hikes, and overall the space to hike is more limited.  This leaves the market in a stop and go attitude towards the USD.  There is a case for rates to rise later this year, but beyond that rates are likely to be raised very cautiously, making the USD vulnerable to any evidence of weaker domestic or global indicators.  With JPY exhibiting strength, we see conditions biased towards a weaker USD and prefer to express this through JPY and Gold at this time.

Fed minutes show caution

The Fed minutes have had a relatively minor impact on US rates. They reversed a little of the rise in rates yesterday in response to Dudley’s comments that a hike was possible in Sep and likely by year-end.

The market may have been wary of something more hawkish in these minutes, pointing to higher risks of a tightening sooner.  However, the minutes didn’t overall raise the urgency to hike.  In fact they indicated that the core decision makers were more cautious since the Brexit vote, even though the immediate risks related to financial market upheaval had diminished.

There are some doves that want to wait for inflation to rise close to target, prepared to risk some overshoot in inflation.  Conversely there are some that see the conditions for some additional tightening already essentially met.  But most participants, and hence the core decision makers, “judged that it was appropriate to wait for additional information that would allow them to evaluate the underlying momentum in economic activity and the labor market and whether inflation was continuing to rise gradually to 2 percent as expected.”

As such, there is no indication of particular urgency to hike at the next meeting.  In comments on Tuesday, Dudley probably accurately reflected the mood of his colleagues that the Fed is likely to hike this year, but is not impatient and will probably wait through the election and decide in December whether to, as Dudley put it, “snug rates up a bit”.

The data since the July meeting probably further builds the case for a hike.  In particular, the labour market and housing market data have improved from Q2.  GDP was weaker than expected, but as Atlanta Fed President Lockhart said on Tuesday, real final sales, stripping out five consecutive months of inventory draw-down, was 1.9% over the last year in Q2, close to the 2% potential.  Retail sales fell-back but only after a strong Q2.  Dudley, Williams and Lockhart, in comments reported earlier in the week, predicted GDP growth above potential in the second half of the year.

A question mark remains over weak business investment, but the minutes indicate that participants can see it stabilizing and improving modestly in coming months.  They see the drag from a weak energy sector as now largely complete.  Looking forward, a pick-up in business investment would be a significant factor boosting Fed comfort with higher rates, raising the importance of the monthly durable goods orders data.

However, the core of the Fed still appear more worried about downside risks to the growth outlook, even though seeing those risks diminished.  And they see little risk that inflation could take-off.  As such they are prepared to wait to be more sure economic momentum is building.  As such, this places the onus on the data to at least stay firm.  Any sign of moderation is likely to delay hikes.  The market is therefore right to not fully price in a rate hike in December.

Immediate Brexit risk from financial market turmoil has diminished, but medium to longer term risks have increased.  The minutes said, “As a consequence of Brexit, economic growth in the United Kingdom and, to a lesser extent, in the euro area would likely be slower than previously anticipated. Moreover, the exit process was expected to entail an extended period of negotiations that, in the view of most participants, had the potential to increase the political and economic uncertainties in that region; several also saw the possibility that complications during the exit process could result in spells of elevated volatility in global financial markets.”

“Some participants” noted additional downside risks related to weak European banks and Chinese economic and financial uncertainty”.  “A few” were uncertain about the strength of the domestic economy.  “Some other participants” did not see uncertainty unusually elevated and viewed the risks as balanced.

Placing this altogether, it appears that the core of the FOMC see risks tilted down, further reason why they may be patient before raising rates.

Furthermore, the Fed staff forecasts also expressed greater downside risks to growth and inflation, adding some weight to the notion that the FOMC will probably wait until to December before giving genuine consideration to raising rates again.

The minutes hardly mentioned the discussion points raised by Dudley and Williams recently that the neutral rate was now seen as lower; down-graded to 3% in the June FOMC.  Both Fed presidents have recently suggested this means that the Fed should be more cautious about raising rates.  This has probably been a key factor in holding down rate expectations in the USA, despite the rebound in payrolls, and weakening the USD.  Not only because it suggests that the next hike may be delayed, but also because it places more doubt on and spaces out further subsequent hikes.

Dudley and Williams are seen as key thought leaders at the FOMC.  As such the market will be wary of this debate influencing FOMC decision-making.  The market will be wondering if it is a topic that Char Yellen might tackle next week in her Jackson Hole Symposium speech.  More controversially will be whether she expands on Williams call for the Fed to debate to case for raising the inflation target and other measures designed to raise the neutral (long term average) policy rate from its current level seen as too low and too close to the lower (near zero) bound for interest rates.