FOMC minutes – low inflation vs. financial stability
Not a big response in US rates and yields to the FOMC minutes, although the USD appeared to weaken somewhat.
The FOMC minutes continue to reveal a broad church with some forecasting fewer hikes, concerned by low inflation and wages growth, fearing that this is spilling into lower inflation expectations. Others have more confidence that the tightening labor market is starting to generate higher wage growth, and concerned that financial stability risks may build if rates are not raised at least gradually, even if inflation may take some time to return to target.
There appears to be a core of members that are prepared to hike in December, barring some significant negative economic surprise. But there are some that appear likely to agree only reluctantly and a few that are unlikely to agree that a hike is appropriate. This is probably consistent with the around 80% probability currently priced-in to the market.
What happens next year is far less clear. The FOMC projected three hikes, but the minutes suggest that the risks lie towards fewer hikes due to concerns that some of the recent low inflation outcomes may reflect more permanent structural factors.
The market is right to keep its path for rate hikes below the FOMC median forecast, given the persistence of low inflation outcomes. The Fed may continue to hike gradually if financial conditions remain easy (reflected in high and steadily rising equities, low bond yields, narrow credit spreads, and a weaker USD). But should there be an interruption to growth or these market indicators, it is likely to pause rate hikes if inflation and inflation expectations remain relatively low.
However, the market has only one hike priced for next year, significantly less than the FOMC median forecast of three hikes. This appears to price-in little possibility that Congress will enact tax reform next year, or that the tightening labor market may feed higher wage growth.
The FOMC does not incorporate any fiscal stimulus in its forecasts, but presumably, the market should be seeing a significant probability that this does happen. Even if political uncertainty in the US is relatively high, it must include some risk of significant tax cuts, possibly above 50%. As such, we think there is more upside risk for US yields and the USD.
It appears that both the Fed and the market remain rather doubtful that inflation will be an issue for some time and thus rate hikes will be gradual and more driven by financial stability concerns.
While higher inflation appears not to be seen as a significant risk, the Fed does see the hurricane disruption delivering temporary boosts to both headline inflation and wages into year end.
It is a little surprising that the market is not fearing that this temporary boost turns into a more permanent increase in inflation, perhaps via higher inflation expectations and more permanent lift in wages growth. The hurricanes (and now fires in California) may generate a kind of fiscal pump to activity that has a lasting impact. Few at the Fed or the market acknowledge this risk.
FOMC not yet banking on fiscal stimulus from tax reform
The FOMC forecasts have not incorporated anything for possible US tax reform. The minutes said, “most participants had not assumed enactment of a fiscal stimulus package in their economic projections or had marked down the expected magnitude of any stimulus.”
Labor market tight
The FOMC was in agreement that the labor market is still tightening, most appear to see it around fully utilized.
However, there were still “some participants” that “saw room for further increases in labor utilization, with a couple of them noting that the employment-to-population ratio and the participation rate for prime-age workers had not fully recovered to pre-recession levels.”
Wages growth expected to rise
“several participants commented that the absence of broad-based upward wage pressures suggested that the sustainable rate of unemployment might be lower than they currently estimated.”
On the other side, “a couple of participants cautioned that a broader acceleration in wages may already have begun, consistent with already-tight labor market conditions.”
There is a range of structural issues that participants thought might account for low wage growth. However, “Most participants expected wage increases to pick up over time as the labor market strengthened further.”
The Fed also sees some near-term upward pressure on wages that may be temporary and relate to the hurricanes. We have already seen some of this in the most recent September wage data that showed higher average hourly earnings driven by utility workers. The minutes said, “It was noted that the expected increase in demand for skilled construction workers for reconstruction in hurricane-affected areas would likely exacerbate existing shortages.”
And, “reports from business contacts in several Districts indicated that employers in labor markets in which demand was high or in which workers in some occupations were in short supply were raising wages noticeably to compete for workers and limit turnover.”
“Many participants continued to believe that the cyclical pressures associated with a tightening labor market or an economy operating above its potential were likely to show through to higher inflation over the medium term.”
Some, but not all, of low inflation outcome is temporary
“Many judged that at least part of the softening in inflation this year was the result of idiosyncratic or one-time factors, and, thus, their effects were likely to fade over time.”
“However, other developments, such as the effects of earlier changes to government health-care programs that had been holding down health-care costs, might continue to do so for some time.”
“Some participants discussed the possibility that secular trends, such as the influence of technological innovations on competition and business pricing, also might have been muting inflationary pressures and could be intensifying.”
“It was noted that other advanced economies were also experiencing low inflation, which might suggest that common global factors could be contributing to persistence of below-target inflation in the United States and abroad.”
Inflation expectations may be too low
“Several participants commented on the importance of longer-run inflation expectations to the outlook for a return of inflation to 2 percent. A number of indicators of inflation expectations, including survey statistics and estimates derived from financial market data, were generally viewed as indicating that longer-run inflation expectations remained reasonably stable, although a few participants saw some of these measures as low or slipping.”
“Participants raised a number of important considerations about the implications of persistently low inflation for the path of the federal funds rate over the medium run.”
“Several expressed concern that the persistence of low rates of inflation might imply that the underlying trend was running below 2 percent, risking a decline in inflation expectations. If so, the appropriate policy path should take into account the need to bolster inflation expectations in order to ensure that inflation returned to 2 percent and to prevent erosion in the credibility of the Committee’s objective.”
“However, a few others pointed out the need to consider the lags in the response of inflation to tightening resource utilization and, thus, increasing upside risks to inflation as the labor market tightened further.”
Closely watching inflation, but near-term trends will be obscured by hurricanes
“Participants generally agreed it would be important to monitor inflation developments closely.”
“Several of them noted that interpreting the next few inflation reports would likely be complicated by the temporary run-up in energy costs and in the prices of other items affected by storm-related disruptions and rebuilding.”
Financial stability concerns vs. low inflation concerns
“many participants expressed concern that the low inflation readings this year might reflect not only transitory factors, but also the influence of developments that could prove more persistent, and it was noted that some patience in removing policy accommodation while assessing trends in inflation was warranted.”
“A few of these participants thought that no further increases in the federal funds rate were called for in the near term or that the upward trajectory of the federal funds rate might appropriately be quite shallow.”
“Some other participants, however, were more worried about upside risks to inflation arising from a labor market that had already reached full employment and was projected to tighten further.”
“Their concerns were heightened by the apparent easing in financial conditions that had developed since the Committee’s policy normalization process was initiated in December 2015. These participants cautioned that an unduly slow pace in removing policy accommodation could result in an overshoot of the Committee’s inflation objective in the medium term that would likely be costly to reverse or could lead to an intensification of financial stability risks or to other imbalances that might prove difficult to unwind.”
A hike in December likely, but with some reluctance and probable dissent
“many participants thought that another increase in the target range later this year was likely to be warranted if the medium-term outlook remained broadly unchanged.”
“Several others noted that, in light of the uncertainty around their outlook for inflation, their decision on whether to take such a policy action would depend importantly on whether the economic data in coming months increased their confidence that inflation was moving up toward the Committee’s objective.
“A few participants thought that additional increases in the federal funds rate should be deferred until incoming information confirmed that the low readings on inflation this year were not likely to persist and that inflation was clearly on a path toward the Committee’s symmetric 2 percent objective over the medium term.”